Tap any paragraph to write a margin note. Your notes collect in the Desk below the text and file under cases with @. The side-by-side margin rail opens on a larger screen.

§
Marginalia
Code · REGISTER · 2007-06-12 · Securities and Exchange Commission (“Commission”) · Notices

Notices. Temporary order and notice of application for a permanent order under section 9(c) of the Investment Company Act of 1940 (the “Act”)

81,118 words·~369 min read·/register/2007/06/12/07-2889

A research copy — for the controlling text, always check the official state or federal source. Not legal advice.

BILLING CODE 7710-12-M SECURITIES AND EXCHANGE COMMISSION [Release No. IC-27851; 812-13391] Barclays Global Fund Advisors; Notice of Application June 6, 2007. AGENCY: Securities and Exchange Commission (“Commission”). ACTION: Temporary order and notice of application for a permanent order under section 9(c) of the Investment Company Act of 1940 (the “Act”). *Summary of Application:* Applicant has received a temporary order exempting it from section 9(a) of the Act, with respect to an injunction entered against Barclays Bank PLC (“Barclays”) on June 6, 2007 by the United States District Court for the Southern District of New York (the “District Court”), until the Commission takes final action on an application for a permanent order.
Applicant also has applied for a permanent order. *Applicants:* Barclays Global Fund Advisors (“BGFA” or the “Applicant”). 1 1 Applicant requests that any relief granted pursuant to the application also apply to any other company of which Barclays is or hereafter becomes an affiliated person (together with Applicant, “Covered Persons”). *Filing Date:* The application was filed on May 30, 2007. Applicant has agreed to file a final amendment during the notice period, the substance of which is reflected in this notice. *Hearing or Notification of Hearing:* An order granting the application will be issued unless the Commission orders a hearing.
Interested persons may request a hearing by writing to the Commission's Secretary and serving Applicant with a copy of the request, personally or by mail. Hearing requests should be received by the Commission by 5:30 p.m. on July 2, 2007, and should be accompanied by proof of service on Applicant, in the form of an affidavit or, for lawyers, a certificate of service. Hearing requests should state the nature of the writer's interest, the reason for the request, and the issues contested.
Persons who wish to be notified of a hearing may request notification by writing to the Commission's Secretary. ADDRESSES: Secretary, U.S. Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090. Applicant, c/o Ira P. Shapiro, Esq., Barclays Global Fund Advisors, 45 Fremont Street, San Francisco, CA 94105. FOR FURTHER INFORMATION CONTACT: Courtney S. Thornton, Senior Counsel, at
(202)551-6812, or Mary Kay Frech, Branch Chief, at
(202)551-6821 (Division of Investment Management, Office of Investment Company Regulation). SUPPLEMENTARY INFORMATION: The following is a temporary order and a summary of the application. The complete application may be obtained for a fee at the Commission's Public Reference Branch, 100 F Street, NE., Washington, DC 20549-0102 (tel. 202-551-5850). Applicant's Representations 1. BGFA, a California corporation registered under the Investment Advisers Act of 1940, serves as investment adviser to the series of iShares Trust, iShares, Inc. and Master Investment Portfolio (the “Advised Funds”), each a registered open-end management investment company. BGFA also serves as sub-adviser to certain series of State Farm Variable Product Trust and American Century Capital Portfolios, Inc. (collectively with the Advised Funds, the “Funds”), each a registered open-end management investment company. BGFA is a wholly-owned subsidiary of Barclays Global Investors, N.A. (“BGI”), a limited purpose trust company that provides investment management services for client accounts and certain unregistered investment vehicles and, through its subsidiaries, is one of the world's largest providers of exchange traded funds (“ETFs”). BGI is a majority-owned subsidiary of Barclays Bank PLC (“Barclays”), which is a major global financial services provider organized under the laws of England and Wales. 2. On June 6, 2007, the District Court entered a final judgment against Barclays in a matter brought by the Commission (the “Final Judgment”). 2 The Commission alleged in the complaint (“Complaint”) that Barclays had violated section 17(a) of the Securities Act of 1933 (“Securities Act”), section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and rule 10b-5 under the Exchange Act by engaging in the purchase and sale of certain distressed debt securities while aware of material, non-public information concerning such distressed debt issuers. 3 Without admitting or denying the allegations in the Complaint, Barclays consented to the entry of the Final Judgment. The Final Judgment permanently enjoins Barclays directly or through its officers, directors, agents and employees from violating section 10(b) of the Exchange Act and rule 10b-5 under the Exchange Act and section 17(a) of the Securities Act (the “Injunction”). 4 Barclays also consented to the payment of disgorgement plus prejudgment interest in addition to civil penalties in an aggregate amount of approximately $10.9 million. 2 *United States Securities and Exchange Commission* v. *Barclays Bank PLC, et al.* , Final Judgment as to Barclays Bank PLC, 07-CV-04472
(MGC)(S.D.N.Y., filed June 4, 2007). 3 Steven J. Landzberg, a former director and proprietary trader for Barclays, was also alleged to have been involved in the conduct underlying the Complaint. 4 The Final Judgment also enjoins Mr. Landzberg from violating section 10(b) of the Exchange Act and rule 10b-5 under the Exchange Act, and section 17(a) of the Securities Act and imposes civil penalties on Mr. Landzberg. The requested temporary and permanent orders will not apply to Mr. Landzberg or to any company of which Mr. Landzberg is or becomes an affiliated person. Applicant's Legal Analysis 1. Section 9(a)(2) of the Act, in relevant part, prohibits a person who has been enjoined from engaging in or continuing any conduct or practice in connection with the purchase or sale of a security from acting, among other things, as an investment adviser or depositor of any registered investment company or a principal underwriter for any registered open-end investment company, registered unit investment trust or registered face-amount certificate company. Section 9(a)(3) of the Act makes the prohibition in section 9(a)(2) applicable to a company, any affiliated person of which has been disqualified under the provisions of section 9(a)(2). “Affiliated person” is defined in section 2(a)(3) of the Act to include any person directly or indirectly controlling, controlled by, or under common control with, the other person. Applicant states that Barclays is an affiliated person of the Applicant within the meaning of section 2(a)(3) of the Act because Barclays controls the Applicant. Applicant states that, as a result of the Injunction, it would be subject to the prohibitions of section 9(a). 2. Section 9(c) of the Act provides that the Commission shall grant an application for an exemption from the disqualification provisions of section 9(a) of the Act if it is established that these provisions, as applied to the applicants, are unduly or disproportionately severe or that the conduct of the applicants has been such as not to make it against the public interest or protection of investors to grant the exemption. Applicant has filed an application pursuant to section 9(c) seeking temporary and permanent orders exempting it from the disqualification provisions of section 9(a) of the Act. 3. Applicant believes it meets the standards for exemption specified in section 9(c). Applicant states that the prohibitions of section 9(a) as applied to it would be unduly and disproportionately severe and that the conduct of Applicant has been such as not to make it against the public interest or the protection of investors to grant the exemption from section 9(a). 4. Applicant states that none of its current or former officers, directors or employees participated in any way in the conduct underlying the Injunction. Applicant further states that the conduct underlying the Injunction did not involve any Funds. 5. Applicant states that the inability to continue providing advisory services to the Funds would result in potentially severe hardships for the Funds and their shareholders. Applicant also states that it has distributed, or will distribute as soon as reasonably practicable, written materials, including an offer to meet in person to discuss the materials, to the boards of directors or trustees of the Funds (the “Boards”), including the directors or trustees who are not “interested persons,” as defined in section 2(a)(19) of the Act, of the Funds and their independent legal counsel, as defined in rule 0-1(a)(6) under the Act, regarding the circumstances of the Final Judgment, any impact on the Funds, and the filing of the application. Applicant will provide the Boards with all information concerning the Final Judgment and the application that is necessary for the Funds to fulfill their disclosure and other obligations under the federal securities laws. 6. Applicant also asserts that, if it were barred from providing services to the Funds, the effect on its business and employees would be severe. Applicant states that it has committed substantial resources to establish an expertise in advising the Funds. Applicant has previously sought and received an exemption under section 9(c) of the Act on one occasion. 5 5 *Wells Fargo Bank, N.A.* , *et al.* , Investment Company Act Release Nos. 16311 (Mar. 11, 1988) (notice and temporary order) and 16355 (Apr. 7, 1988) (permanent order). Applicant's Condition Applicant agrees that any order granting the requested relief shall be subject to the following condition: Any temporary exemption granted pursuant to the application shall be without prejudice to, and shall not limit the Commission's rights in any manner with respect to, any Commission investigation of, or administrative proceedings involving or against, Covered Persons, including, without limitation, the consideration by the Commission of a permanent exemption from section 9(a) of the Act requested pursuant to the application or the revocation or removal of any temporary exemption granted under the Act in connection with the application. Temporary Order The Commission has considered the matter and finds that Applicant has made the necessary showing to justify granting a temporary exemption. Accordingly, *It is hereby ordered,* pursuant to section 9(c) of the Act, that the Covered Persons are granted a temporary exemption from the provisions of section 9(a), effective forthwith, solely with respect to the Injunction, subject to the condition in the application, until the date the Commission takes final action on an application for a permanent order. By the Commission. Florence E. Harmon, Deputy Secretary. [FR Doc. E7-11295 Filed 6-11-07; 8:45 am] BILLING CODE 8010-01-P SECURITIES AND EXCHANGE COMMISSION [Release No. 34-55876; File No. PCAOB-2007-02] Public Company Accounting Oversight Board; Notice of Filing of Proposed Rule on Auditing Standard No. 5, an Audit of Internal Control Over Financial Reporting That Is Integrated With an Audit of Financial Statements, and Related Independence Rule and Conforming Amendments June 7, 2007. Pursuant to Section 107(b) of the Sarbanes-Oxley Act of 2002 (the “Act”), notice is hereby given that on May 25, 2007, the Public Company Accounting Oversight Board (the “Board” or the “PCAOB”) filed with the Securities and Exchange Commission (the “Commission” or “SEC”) the proposed rules described in Items I and II below, which items have been prepared by the Board. The Commission is publishing this notice to solicit comments on the proposed rules from interested persons. The text of the proposed rules consists of proposed Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That is Integrated with an Audit of Financial Statements* , and Related Independence Rule and conforming amendments to its auditing standards. I. Board's Statement of the Terms of Substance of the Proposed Rules On May 24, 2007, the Board adopted Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That is Integrated with an Audit of Financial Statements (“Auditing Standard No. 5”); Rule 3525, Audit Committee Pre-Approval of Non-Audit Services Related to Internal Control Over Financial Reporting* , and conforming amendments to its auditing standards. The proposed rule text is set out below. Auditing Standard No. 5—An Audit of Internal Control Over Financial Reporting That Is Integrated With an Audit of Financial Statements Table of Contents Paragraph Introduction 1-8 Integrating the Audits 6-8 Planning the Audit 9-20 Role of Risk Assessment 10-12 Scaling the Audit 13 Addressing the Risk of Fraud 14-15 Using the Work of Others 16-19 Materiality 20 Using a Top-Down Approach 21-41 Identifying Entity-Level Controls 22-27 Control Environment 25 Period-end Financial Reporting Process 26-27 Identifying Significant Accounts and Disclosures and Their Relevant Assertions 28-33 Understanding Likely Sources of Misstatement 34-38 Performing Walkthroughs 37-38 Selecting Controls to Test 39-41 Testing Controls 42-61 Testing Design Effectiveness 42-43 Testing Operating Effectiveness 44-45 Relationship of Risk to the Evidence to be Obtained 46-56 Nature of Tests of Controls 50-51 Timing of Tests of Controls 52-53 Extent of Tests of Controls 54 Roll-Forward Procedures 55-56 Special Considerations for Subsequent Years' Audits 57-61 Evaluating Identified Deficiencies 62-70 Indicators of Material Weaknesses 69-70 Wrapping-Up 71-84 Forming an Opinion 71-74 Obtaining Written Representations 75-77 Communicating Certain Matters 78-84 Reporting on Internal Control 85-98 Separate or Combined Reports 86-88 Report Date 89 Material Weaknesses 90-92 Subsequent Events 93-98 Appendices Appendix A—Definitions A1-A11 Appendix B—Special Topics B1-B33 Integration of Audits B1-B9 Multiple Locations Scoping Decisions B10-B16 Use of Service Organizations B17-B27 Benchmarking of Automated Controls B28-B33 Appendix C—Special Reporting Situations C1-C17 Report Modifications C1-C15 Filings Under Federal Securities Statutes C16-C17 Introduction 1. This standard establishes requirements and provides direction that applies when an auditor is engaged to perform an audit of *management's assessment* 1 of the effectiveness of *internal control over financial reporting* (“the audit of internal control over financial reporting”) that is integrated with an audit of the financial statements. 2 1 Terms defined in Appendix A, *Definitions* , are set in boldface type ( *italics* in the **Federal Register** printing) the first time they appear. 2 This auditing standard supersedes Auditing Standard No. 2, *An Audit of Internal Control Over Financial Reporting Performed in Conjunction with An Audit of Financial Statements* , and is the standard on attestation engagements referred to in Section 404(b) of the Act. It also is the standard referred to in Section 103(a)(2)(A)(iii) of the Act. 2. Effective internal control over financial reporting provides reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes. 3 If one or more *material weaknesses* exist, the company's internal control over financial reporting cannot be considered effective. 4 3 *See* Securities Exchange Act Rules 13a-15(f) and 15d-15(f), 17 CFR §§ 240.13a-15(f) and 240.15d-15(f); Paragraph A5. 4 *See* Item 308 of Regulation S-K, 17 CFR 229.308. 3. The auditor's objective in an audit of internal control over financial reporting is to express an opinion on the effectiveness of the company's internal control over financial reporting. Because a company's internal control cannot be considered effective if one or more material weaknesses exist, to form a basis for expressing an opinion, the auditor must plan and perform the audit to obtain competent evidence that is sufficient to obtain reasonable assurance 5 about whether material weaknesses exist as of the date specified in management's assessment. A material weakness in internal control over financial reporting may exist even when financial statements are not materially misstated. 5 *See* AU sec. 230, *Due Professional Care in the Performance of Work* , for further discussion of the concept of reasonable assurance in an audit. 4. The general standards 6 are applicable to an audit of internal control over financial reporting. Those standards require technical training and proficiency as an auditor, independence, and the exercise of due professional care, including professional skepticism. This standard establishes the fieldwork and reporting standards applicable to an audit of internal control over financial reporting. 6 *See* AU sec. 150, *Generally Accepted Auditing Standards* . 5. The auditor should use the same suitable, recognized control framework to perform his or her audit of internal control over financial reporting as management uses for its annual evaluation of the effectiveness of the company's internal control over financial reporting. 7 7 *See* Securities Exchange Act Rules 13a-15(c) and 15d-15(c), 17 CFR 240.13a-15(c) and 240.15d-15(c). SEC rules require management to base its evaluation of the effectiveness of the company's internal control over financial reporting on a suitable, recognized control framework (also known as control criteria) established by a body or group that followed due-process procedures, including the broad distribution of the framework for public comment. For example, the report of the Committee of Sponsoring Organizations of the Treadway Commission (known as the COSO report) provides such a framework, as does the report published by the Financial Reporting Council, Internal Control Revised Guidance for Directors on the Combined Code, October 2005 (known as the Turnbull Report). Integrating the Audits 6. The audit of internal control over financial reporting should be integrated with the audit of the financial statements. The objectives of the audits are not identical, however, and the auditor must plan and perform the work to achieve the objectives of both audits. 7. In an integrated audit of internal control over financial reporting and the financial statements, the auditor should design his or her testing of controls to accomplish the objectives of both audits simultaneously— • To obtain sufficient evidence to support the auditor's opinion on internal control over financial reporting as of year-end, and • To obtain sufficient evidence to support the auditor's control risk assessments for purposes of the audit of financial statements. 8. Obtaining sufficient evidence to support control risk assessments as low for purposes of the financial statement audit ordinarily allows the auditor to reduce the amount of audit work that otherwise would have been necessary to opine on the financial statements. ( *See* Appendix B for additional direction on integration.) Note: In some circumstances, particularly in some audits of smaller and less complex companies, the auditor might choose not to assess control risk as low for purposes of the audit of the financial statements. In such circumstances, the auditor's tests of the operating effectiveness of controls would be performed principally for the purpose of supporting his or her opinion on whether the company's internal control over financial reporting is effective as of year-end. The results of the auditor's financial statement auditing procedures also should inform his or her risk assessments in determining the testing necessary to conclude on the effectiveness of a control. Planning the Audit 9. The auditor should properly plan the audit of internal control over financial reporting and properly supervise any assistants. When planning an integrated audit, the auditor should evaluate whether the following matters are important to the company's financial statements and internal control over financial reporting and, if so, how they will affect the auditor's procedures— • Knowledge of the company's internal control over financial reporting obtained during other engagements performed by the auditor; • Matters affecting the industry in which the company operates, such as financial reporting practices, economic conditions, laws and regulations, and technological changes; • Matters relating to the company's business, including its organization, operating characteristics, and capital structure; • The extent of recent changes, if any, in the company, its operations, or its internal control over financial reporting; • The auditor's preliminary judgments about materiality, risk, and other factors relating to the determination of material weaknesses; • Control deficiencies previously communicated to the audit committee 8 or management; 8 If no audit committee exists, all references to the audit committee in this standard apply to the entire board of directors of the company. *See* 15 U.S.C. 78c(a)58 and 7201(a)(3). • Legal or regulatory matters of which the company is aware; • The type and extent of available evidence related to the effectiveness of the company's internal control over financial reporting; • Preliminary judgments about the effectiveness of internal control over financial reporting; • Public information about the company relevant to the evaluation of the likelihood of material financial statement misstatements and the effectiveness of the company's internal control over financial reporting; • Knowledge about risks related to the company evaluated as part of the auditor's client acceptance and retention evaluation; and • The relative complexity of the company's operations. Note: Many smaller companies have less complex operations. Additionally, some larger, complex companies may have less complex units or processes. Factors that might indicate less complex operations include: fewer business lines; less complex business processes and financial reporting systems; more centralized accounting functions; extensive involvement by senior management in the day-to-day activities of the business; and fewer levels of management, each with a wide span of control. Role of Risk Assessment 10. Risk assessment underlies the entire audit process described by this standard, including the determination of *significant accounts and disclosures* and *relevant assertions* , the selection of controls to test, and the determination of the evidence necessary for a given control. 11. A direct relationship exists between the degree of risk that a material weakness could exist in a particular area of the company's internal control over financial reporting and the amount of audit attention that should be devoted to that area. In addition, the risk that a company's internal control over financial reporting will fail to prevent or detect misstatement caused by fraud usually is higher than the risk of failure to prevent or detect error. The auditor should focus more of his or her attention on the areas of highest risk. On the other hand, it is not necessary to test controls that, even if deficient, would not present a reasonable possibility of material misstatement to the financial statements. 12. The complexity of the organization, business unit, or process, will play an important role in the auditor's risk assessment and the determination of the necessary procedures. Scaling the Audit 13. The size and complexity of the company, its business processes, and business units, may affect the way in which the company achieves many of its *control objectives* . The size and complexity of the company also might affect the risks of misstatement and the controls necessary to address those risks. Scaling is most effective as a natural extension of the risk-based approach and applicable to the audits of all companies. Accordingly, a smaller, less complex company, or even a larger, less complex company might achieve its control objectives differently than a more complex company. 9 9 The SEC Advisory Committee on Smaller Public Companies considered a company's size with respect to compliance with the internal control reporting provisions of the Act. *See* Advisory Committee on Smaller Public Companies to the United States Securities and Exchange Commission, Final Report, at p. 5 (April 23, 2006). Addressing the Risk of Fraud 14. When planning and performing the audit of internal control over financial reporting, the auditor should take into account the results of his or her fraud risk assessment. 10 As part of identifying and testing entity-level controls, as discussed beginning at paragraph 22, and selecting other controls to test, as discussed beginning at paragraph 39, the auditor should evaluate whether the company's controls sufficiently address identified risks of material misstatement due to fraud and controls intended to address the risk of management override of other controls. Controls that might address these risks include— 10 *See* paragraphs .19 through .42 of AU sec. 316, *Consideration of Fraud in a Financial Statement Audit* , regarding identifying risks that may result in material misstatement due to fraud. • Controls over significant, unusual transactions, particularly those that result in late or unusual journal entries; • Controls over journal entries and adjustments made in the period-end financial reporting process; • Controls over related party transactions; • Controls related to significant management estimates; and • Controls that mitigate incentives for, and pressures on, management to falsify or inappropriately manage financial results. 15. If the auditor identifies deficiencies in controls designed to prevent or detect fraud during the audit of internal control over financial reporting, the auditor should take into account those deficiencies when developing his or her response to risks of material misstatement during the financial statement audit, as provided in AU sec. 316.44 and .45. Using the Work of Others 16. The auditor should evaluate the extent to which he or she will use the work of others to reduce the work the auditor might otherwise perform himself or herself. AU sec. 322, *The Auditor's Consideration of the Internal Audit Function in an Audit of Financial Statements,* applies in an integrated audit of the financial statements and internal control over financial reporting. 17. For purposes of the audit of internal control, however, the auditor may use the work performed by, or receive direct assistance from, internal auditors, company personnel (in addition to internal auditors), and third parties working under the direction of management or the audit committee that provides evidence about the effectiveness of internal control over financial reporting. In an integrated audit of internal control over financial reporting and the financial statements, the auditor also may use this work to obtain evidence supporting the auditor's assessment of control risk for purposes of the audit of the financial statements. 18. The auditor should assess the competence and objectivity of the persons whose work the auditor plans to use to determine the extent to which the auditor may use their work. The higher the degree of competence and objectivity, the greater use the auditor may make of the work. The auditor should apply paragraphs .09 through .11 of AU sec. 322 to assess the competence and objectivity of internal auditors. The auditor should apply the principles underlying those paragraphs to assess the competence and objectivity of persons other than internal auditors whose work the auditor plans to use. Note: For purposes of using the work of others, competence means the attainment and maintenance of a level of understanding and knowledge that enables that person to perform ably the tasks assigned to them, and objectivity means the ability to perform those tasks impartially and with intellectual honesty. To assess competence, the auditor should evaluate factors about the person's qualifications and ability to perform the work the auditor plans to use. To assess objectivity, the auditor should evaluate whether factors are present that either inhibit or promote a person's ability to perform with the necessary degree of objectivity the work the auditor plans to use. Note: The auditor should not use the work of persons who have a low degree of objectivity, regardless of their level of competence. Likewise, the auditor should not use the work of persons who have a low level of competence regardless of their degree of objectivity. Personnel whose core function is to serve as a testing or compliance authority at the company, such as internal auditors, normally are expected to have greater competence and objectivity in performing the type of work that will be useful to the auditor. 19. The extent to which the auditor may use the work of others in an audit of internal control also depends on the risk associated with the control being tested. As the risk associated with a control increases, the need for the auditor to perform his or her own work on the control increases. Materiality 20. In planning the audit of internal control over financial reporting, the auditor should use the same materiality considerations he or she would use in planning the audit of the company's annual financial statements. 11 11 *See* AU sec. 312, *Audit Risk and Materiality in Conducting an Audit* , which provides additional explanation of materiality. Using a Top-Down Approach 21. The auditor should use a top-down approach to the audit of internal control over financial reporting to select the controls to test. A top-down approach begins at the financial statement level and with the auditor's understanding of the overall risks to internal control over financial reporting. The auditor then focuses on entity-level controls and works down to significant accounts and disclosures and their relevant assertions. This approach directs the auditor's attention to accounts, disclosures, and assertions that present a reasonable possibility of material misstatement to the *financial statements and related disclosures* . The auditor then verifies his or her understanding of the risks in the company's processes and selects for testing those controls that sufficiently address the assessed risk of misstatement to each relevant assertion. Note: The top-down approach describes the auditor's sequential thought process in identifying risks and the controls to test, not necessarily the order in which the auditor will perform the auditing procedures. Identifying Entity-Level Controls 22. The auditor must test those entity-level controls that are important to the auditor's conclusion about whether the company has effective internal control over financial reporting. The auditor's evaluation of entity-level controls can result in increasing or decreasing the testing that the auditor otherwise would have performed on other controls. 23. Entity-level controls vary in nature and precision— • Some entity-level controls, such as certain control environment controls, have an important, but indirect, effect on the likelihood that a misstatement will be detected or prevented on a timely basis. These controls might affect the other controls the auditor selects for testing and the nature, timing, and extent of procedures the auditor performs on other controls. • Some entity-level controls monitor the effectiveness of other controls. Such controls might be designed to identify possible breakdowns in lower-level controls, but not at a level of precision that would, by themselves, sufficiently address the assessed risk that misstatements to a relevant assertion will be prevented or detected on a timely basis. These controls, when operating effectively, might allow the auditor to reduce the testing of other controls. • Some entity-level controls might be designed to operate at a level of precision that would adequately prevent or detect on a timely basis misstatements to one or more relevant assertions. If an entity-level control sufficiently addresses the assessed risk of misstatement, the auditor need not test additional controls relating to that risk. 24. Entity-level controls include— • Controls related to the control environment; • Controls over management override; Note: Controls over management override are important to effective internal control over financial reporting for all companies, and may be particularly important at smaller companies because of the increased involvement of senior management in performing controls and in the period-end financial reporting process. For smaller companies, the controls that address the risk of management override might be different from those at a larger company. For example, a smaller company might rely on more detailed oversight by the audit committee that focuses on the risk of management override. • The company's risk assessment process; • Centralized processing and controls, including shared service environments; • Controls to monitor results of operations; • Controls to monitor other controls, including activities of the internal audit function, the audit committee, and self-assessment programs; • Controls over the period-end financial reporting process; and • Policies that address significant business control and risk management practices. 25. *Control Environment.* Because of its importance to effective internal control over financial reporting, the auditor must evaluate the control environment at the company. As part of evaluating the control environment, the auditor should assess— • Whether management's philosophy and operating style promote effective internal control over financial reporting; • Whether sound integrity and ethical values, particularly of top management, are developed and understood; and • Whether the Board or audit committee understands and exercises oversight responsibility over financial reporting and internal control. 26. *Period-end Financial Reporting Process.* Because of its importance to financial reporting and to the auditor's opinions on internal control over financial reporting and the financial statements, the auditor must evaluate the period-end financial reporting process. The period-end financial reporting process includes the following— • Procedures used to enter transaction totals into the general ledger; • Procedures related to the selection and application of accounting policies; • Procedures used to initiate, authorize, record, and process journal entries in the general ledger; • Procedures used to record recurring and nonrecurring adjustments to the annual and quarterly financial statements; and • Procedures for preparing annual and quarterly financial statements and related disclosures. Note: Because the annual period-end financial reporting process normally occurs after the “as-of” date of management's assessment, those controls usually cannot be tested until after the as-of date. 27. As part of evaluating the period-end financial reporting process, the auditor should assess— • Inputs, procedures performed, and outputs of the processes the company uses to produce its annual and quarterly financial statements; • The extent of information technology (“IT”) involvement in the period-end financial reporting process; • Who participates from management; • The locations involved in the period-end financial reporting process; • The types of adjusting and consolidating entries; and • The nature and extent of the oversight of the process by management, the board of directors, and the audit committee. Note: The auditor should obtain sufficient evidence of the effectiveness of those quarterly controls that are important to determining whether the company's controls sufficiently address the assessed risk of misstatement to each relevant assertion as of the date of management's assessment. However, the auditor is not required to obtain sufficient evidence for each quarter individually. Identifying Significant Accounts and Disclosures and Their Relevant Assertions 28. The auditor should identify significant accounts and disclosures and their relevant assertions. Relevant assertions are those financial statement assertions that have a reasonable possibility of containing a misstatement that would cause the financial statements to be materially misstated. The financial statement assertions include 12 — 12 *See* AU sec. 326, *Evidential Matter,* which provides additional information on financial statement assertions. • Existence or occurrence • Completeness • Valuation or allocation • Rights and obligations • Presentation and disclosure Note: The auditor may base his or her work on assertions that differ from those in this standard if the auditor has selected and tested controls over the pertinent risks in each significant account and disclosure that have a reasonable possibility of containing misstatements that would cause the financial statements to be materially misstated. 29. To identify significant accounts and disclosures and their relevant assertions, the auditor should evaluate the qualitative and quantitative risk factors related to the financial statement line items and disclosures. Risk factors relevant to the identification of significant accounts and disclosures and their relevant assertions include— • Size and composition of the account; • Susceptibility to misstatement due to errors or fraud; • Volume of activity, complexity, and homogeneity of the individual transactions processed through the account or reflected in the disclosure; • Nature of the account or disclosure; • Accounting and reporting complexities associated with the account or disclosure; • Exposure to losses in the account; • Possibility of significant contingent liabilities arising from the activities reflected in the account or disclosure; • Existence of related party transactions in the account; and • Changes from the prior period in account or disclosure characteristics. 30. As part of identifying significant accounts and disclosures and their relevant assertions, the auditor also should determine the likely sources of potential misstatements that would cause the financial statements to be materially misstated. The auditor might determine the likely sources of potential misstatements by asking himself or herself “what could go wrong?” within a given significant account or disclosure. 31. The risk factors that the auditor should evaluate in the identification of significant accounts and disclosures and their relevant assertions are the same in the audit of internal control over financial reporting as in the audit of the financial statements; accordingly, significant accounts and disclosures and their relevant assertions are the same for both audits. Note: In the financial statement audit, the auditor might perform substantive auditing procedures on financial statement accounts, disclosures and assertions that are not determined to be significant accounts and disclosures and relevant assertions. 13 13 This is because his or her assessment of the risk that undetected misstatement would cause the financial statements to be materially misstated is unacceptably high ( *see* AU sec. 312.39 for further discussion about undetected misstatement) or as a means of introducing unpredictability in the procedures performed ( *see* paragraph 61 and AU sec. 316.50 for further discussion about predictability of auditing procedures). 32. The components of a potential significant account or disclosure might be subject to significantly differing risks. If so, different controls might be necessary to adequately address those risks. 33. When a company has multiple locations or business units, the auditor should identify significant accounts and disclosures and their relevant assertions based on the consolidated financial statements. Having made those determinations, the auditor should then apply the direction in Appendix B for multiple locations scoping decisions. Understanding Likely Sources of Misstatement 34. To further understand the likely sources of potential misstatements, and as a part of selecting the controls to test, the auditor should achieve the following objectives— • Understand the flow of transactions related to the relevant assertions, including how these transactions are initiated, authorized, processed, and recorded; • Verify that the auditor has identified the points within the company's processes at which a misstatement—including a misstatement due to fraud—could arise that, individually or in combination with other misstatements, would be material; • Identify the controls that management has implemented to address these potential misstatements; and • Identify the controls that management has implemented over the prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could result in a material misstatement of the financial statements. 35. Because of the degree of judgment required, the auditor should either perform the procedures that achieve the objectives in paragraph 34 himself or herself or supervise the work of others who provide direct assistance to the auditor, as described in AU sec. 322. 36. The auditor also should understand how IT affects the company's flow of transactions. The auditor should apply paragraphs .16 through .20, .30 through .32, and .77 through .79, of AU sec. 319, *Consideration of Internal Control in a Financial Statement Audit,* which discuss the effect of information technology on internal control over financial reporting and the risks to assess. Note: The identification of risks and controls within IT is not a separate evaluation. Instead, it is an integral part of the top-down approach used to identify significant accounts and disclosures and their relevant assertions, and the controls to test, as well as to assess risk and allocate audit effort as described by this standard. 37. *Performing Walkthroughs.* Performing walkthroughs will frequently be the most effective way of achieving the objectives in paragraph 34. In performing a walkthrough, the auditor follows a transaction from origination through the company's processes, including information systems, until it is reflected in the company's financial records, using the same documents and information technology that company personnel use. Walkthrough procedures usually include a combination of inquiry, observation, inspection of relevant documentation, and re-performance of controls. 38. In performing a walkthrough, at the points at which important processing procedures occur, the auditor questions the company's personnel about their understanding of what is required by the company's prescribed procedures and controls. These probing questions, combined with the other walkthrough procedures, allow the auditor to gain a sufficient understanding of the process and to be able to identify important points at which a necessary control is missing or not designed effectively. Additionally, probing questions that go beyond a narrow focus on the single transaction used as the basis for the walkthrough allow the auditor to gain an understanding of the different types of significant transactions handled by the process. Selecting Controls To Test 39. The auditor should test those controls that are important to the auditor's conclusion about whether the company's controls sufficiently address the assessed risk of misstatement to each relevant assertion. 40. There might be more than one control that addresses the assessed risk of misstatement to a particular relevant assertion; conversely, one control might address the assessed risk of misstatement to more than one relevant assertion. It is neither necessary to test all controls related to a relevant assertion nor necessary to test redundant controls, unless redundancy is itself a control objective. 41. The decision as to whether a control should be selected for testing depends on which controls, individually or in combination, sufficiently address the assessed risk of misstatement to a given relevant assertion rather than on how the control is labeled ( *e.g.* , entity-level control, transaction-level control, control activity, monitoring control, *preventive control, detective control* ). Testing Controls Testing Design Effectiveness 42. The auditor should test the design effectiveness of controls by determining whether the company's controls, if they are operated as prescribed by persons possessing the necessary authority and competence to perform the control effectively, satisfy the company's control objectives and can effectively prevent or detect errors or fraud that could result in material misstatements in the financial statements. Note: A smaller, less complex company might achieve its control objectives in a different manner from a larger, more complex organization. For example, a smaller, less complex company might have fewer employees in the accounting function, limiting opportunities to segregate duties and leading the company to implement alternative controls to achieve its control objectives. In such circumstances, the auditor should evaluate whether those alternative controls are effective. 43. Procedures the auditor performs to test design effectiveness include a mix of inquiry of appropriate personnel, observation of the company's operations, and inspection of relevant documentation. Walkthroughs that include these procedures ordinarily are sufficient to evaluate design effectiveness. Testing Operating Effectiveness 44. The auditor should test the operating effectiveness of a control by determining whether the control is operating as designed and whether the person performing the control possesses the necessary authority and competence to perform the control effectively. Note: In some situations, particularly in smaller companies, a company might use a third party to provide assistance with certain financial reporting functions. When assessing the competence of personnel responsible for a company's financial reporting and associated controls, the auditor may take into account the combined competence of company personnel and other parties that assist with functions related to financial reporting. 45. Procedures the auditor performs to test operating effectiveness include a mix of inquiry of appropriate personnel, observation of the company's operations, inspection of relevant documentation, and re-performance of the control. Relationship of Risk to the Evidence To Be Obtained 46. For each control selected for testing, the evidence necessary to persuade the auditor that the control is effective depends upon the risk associated with the control. The risk associated with a control consists of the risk that the control might not be effective and, if not effective, the risk that a material weakness would result. As the risk associated with the control being tested increases, the evidence that the auditor should obtain also increases. Note: Although the auditor must obtain evidence about the effectiveness of controls for each relevant assertion, the auditor is not responsible for obtaining sufficient evidence to support an opinion about the effectiveness of each individual control. Rather, the auditor's objective is to express an opinion on the company's internal control over financial reporting overall. This allows the auditor to vary the evidence obtained regarding the effectiveness of individual controls selected for testing based on the risk associated with the individual control. 47. Factors that affect the risk associated with a control include— • The nature and materiality of misstatements that the control is intended to prevent or detect; • The inherent risk associated with the related account(s) and assertion(s); • Whether there have been changes in the volume or nature of transactions that might adversely affect control design or operating effectiveness; • Whether the account has a history of errors; • The effectiveness of entity-level controls, especially controls that monitor other controls; • The nature of the control and the frequency with which it operates; • The degree to which the control relies on the effectiveness of other controls ( *e.g.* , the control environment or information technology general controls); • The competence of the personnel who perform the control or monitor its performance and whether there have been changes in key personnel who perform the control or monitor its performance; • Whether the control relies on performance by an individual or is automated ( *i.e.* , an automated control would generally be expected to be lower risk if relevant information technology general controls are effective); and Note: A less complex company or business unit with simple business processes and centralized accounting operations might have relatively simple information systems that make greater use of off-the-shelf packaged software without modification. In the areas in which off-the-shelf software is used, the auditor's testing of information technology controls might focus on the application controls built into the pre-packaged software that management relies on to achieve its control objectives and the IT general controls that are important to the effective operation of those application controls. • The complexity of the control and the significance of the judgments that must be made in connection with its operation. Note: Generally, a conclusion that a control is not operating effectively can be supported by less evidence than is necessary to support a conclusion that a control is operating effectively. 48. When the auditor identifies deviations from the company's controls, he or she should determine the effect of the deviations on his or her assessment of the risk associated with the control being tested and the evidence to be obtained, as well as on the operating effectiveness of the control. Note: Because effective internal control over financial reporting cannot, and does not, provide absolute assurance of achieving the company's control objectives, an individual control does not necessarily have to operate without any deviation to be considered effective. 49. The evidence provided by the auditor's tests of the effectiveness of controls depends upon the mix of the nature, timing, and extent of the auditor's procedures. Further, for an individual control, different combinations of the nature, timing, and extent of testing may provide sufficient evidence in relation to the risk associated with the control. Note: Walkthroughs usually consist of a combination of inquiry of appropriate personnel, observation of the company's operations, inspection of relevant documentation, and re-performance of the control and might provide sufficient evidence of operating effectiveness, depending on the risk associated with the control being tested, the specific procedures performed as part of the walkthrough and the results of those procedures. 50. *Nature of Tests of Controls.* Some types of tests, by their nature, produce greater evidence of the effectiveness of controls than other tests. The following tests that the auditor might perform are presented in order of the evidence that they ordinarily would produce, from least to most: inquiry, observation, inspection of relevant documentation, and re-performance of a control. Note: Inquiry alone does not provide sufficient evidence to support a conclusion about the effectiveness of a control. 51. The nature of the tests of effectiveness that will provide competent evidence depends, to a large degree, on the nature of the control to be tested, including whether the operation of the control results in documentary evidence of its operation. Documentary evidence of the operation of some controls, such as management's philosophy and operating style, might not exist. Note: A smaller, less complex company or unit might have less formal documentation regarding the operation of its controls. In those situations, testing controls through inquiry combined with other procedures, such as observation of activities, inspection of less formal documentation, or re-performance of certain controls, might provide sufficient evidence about whether the control is effective. 52. *Timing of Tests of Controls.* Testing controls over a greater period of time provides more evidence of the effectiveness of controls than testing over a shorter period of time. Further, testing performed closer to the date of management's assessment provides more evidence than testing performed earlier in the year. The auditor should balance performing the tests of controls closer to the as-of date with the need to test controls over a sufficient period of time to obtain sufficient evidence of operating effectiveness. 53. Prior to the date specified in management's assessment, management might implement changes to the company's controls to make them more effective or efficient or to address control deficiencies. If the auditor determines that the new controls achieve the related objectives of the control criteria and have been in effect for a sufficient period to permit the auditor to assess their design and operating effectiveness by performing tests of controls, he or she will not need to test the design and operating effectiveness of the superseded controls for purposes of expressing an opinion on internal control over financial reporting. If the operating effectiveness of the superseded controls is important to the auditor's control risk assessment, the auditor should test the design and operating effectiveness of those superseded controls, as appropriate. ( *See* additional direction on integration beginning at paragraph B1.) 54. *Extent of Tests of Controls.* The more extensively a control is tested, the greater the evidence obtained from that test. 55. *Roll-Forward Procedures.* When the auditor reports on the effectiveness of controls as of a specific date and obtains evidence about the operating effectiveness of controls at an interim date, he or she should determine what additional evidence concerning the operation of the controls for the remaining period is necessary. 56. The additional evidence that is necessary to update the results of testing from an interim date to the company's year-end depends on the following factors— • The specific control tested prior to the as-of date, including the risks associated with the control and the nature of the control, and the results of those tests; • The sufficiency of the evidence of effectiveness obtained at an interim date; • The length of the remaining period; and • The possibility that there have been any significant changes in internal control over financial reporting subsequent to the interim date. Note: In some circumstances, such as when evaluation of the foregoing factors indicates a low risk that the controls are no longer effective during the roll-forward period, inquiry alone might be sufficient as a roll-forward procedure. Special Considerations for Subsequent Years' Audits 57. In subsequent years' audits, the auditor should incorporate knowledge obtained during past audits he or she performed of the company's internal control over financial reporting into the decision-making process for determining the nature, timing, and extent of testing necessary. This decision-making process is described in paragraphs 46 through 56. 58. Factors that affect the risk associated with a control in subsequent years' audits include those in paragraph 47 and the following — • The nature, timing, and extent of procedures performed in previous audits, • The results of the previous years' testing of the control, and • Whether there have been changes in the control or the process in which it operates since the previous audit. 59. After taking into account the risk factors identified in paragraphs 47 and 58, the additional information available in subsequent years' audits might permit the auditor to assess the risk as lower than in the initial year. This, in turn, might permit the auditor to reduce testing in subsequent years. 60. The auditor may also use a benchmarking strategy for automated application controls in subsequent years' audits. Benchmarking is described further beginning at paragraph B28. 61. In addition, the auditor should vary the nature, timing, and extent of testing of controls from year to year to introduce unpredictability into the testing and respond to changes in circumstances. For this reason, each year the auditor might test controls at a different interim period, increase or reduce the number and types of tests performed, or change the combination of procedures used. Evaluating Identified Deficiencies 62. The auditor must evaluate the severity of each control *deficiency* that comes to his or her attention to determine whether the deficiencies, individually or in combination, are material weaknesses as of the date of management's assessment. In planning and performing the audit, however, the auditor is not required to search for deficiencies that, individually or in combination, are less severe than a material weakness. 63. The severity of a deficiency depends on— • Whether there is a reasonable possibility that the company's controls will fail to prevent or detect a misstatement of an account balance or disclosure; and • The magnitude of the potential misstatement resulting from the deficiency or deficiencies. 64. The severity of a deficiency does not depend on whether a misstatement actually has occurred but rather on whether there is a reasonable possibility that the company's controls will fail to prevent or detect a misstatement. 65. Risk factors affect whether there is a reasonable possibility that a deficiency, or a combination of deficiencies, will result in a misstatement of an account balance or disclosure. The factors include, but are not limited to, the following— • The nature of the financial statement accounts, disclosures, and assertions involved; • The susceptibility of the related asset or liability to loss or fraud; • The subjectivity, complexity, or extent of judgment required to determine the amount involved; • The interaction or relationship of the control with other controls, including whether they are interdependent or redundant; • The interaction of the deficiencies; and • The possible future consequences of the deficiency. Note: The evaluation of whether a control deficiency presents a reasonable possibility of misstatement can be made without quantifying the probability of occurrence as a specific percentage or range. Note: Multiple control deficiencies that affect the same financial statement account balance or disclosure increase the likelihood of misstatement and may, in combination, constitute a material weakness, even though such deficiencies may individually be less severe. Therefore, the auditor should determine whether individual control deficiencies that affect the same significant account or disclosure, relevant assertion, or component of internal control collectively result in a material weakness. 66. Factors that affect the magnitude of the misstatement that might result from a deficiency or deficiencies in controls include, but are not limited to, the following— • The financial statement amounts or total of transactions exposed to the deficiency; and • The volume of activity in the account balance or class of transactions exposed to the deficiency that has occurred in the current period or that is expected in future periods. 67. In evaluating the magnitude of the potential misstatement, the maximum amount that an account balance or total of transactions can be overstated is generally the recorded amount, while understatements could be larger. Also, in many cases, the probability of a small misstatement will be greater than the probability of a large misstatement. 68. The auditor should evaluate the effect of compensating controls when determining whether a control deficiency or combination of deficiencies is a material weakness. To have a mitigating effect, the compensating control should operate at a level of precision that would prevent or detect a misstatement that could be material. Indicators of Material Weaknesses 69. Indicators of material weaknesses in internal control over financial reporting include— • Identification of fraud, whether or not material, on the part of senior management; 14 14 For the purpose of this indicator, the term “senior management” includes the principal executive and financial officers signing the company's certifications as required under Section 302 of the Act as well as any other members of senior management who play a significant role in the company's financial reporting process. • Restatement of previously issued financial statements to reflect the correction of a material misstatement; 15 15 *See* Financial Accounting Standards Board Statement No. 154, *Accounting Changes and Error Corrections* , regarding the correction of a misstatement. • Identification by the auditor of a material misstatement of financial statements in the current period in circumstances that indicate that the misstatement would not have been detected by the company's internal control over financial reporting; and • Ineffective oversight of the company's external financial reporting and internal control over financial reporting by the company’s audit committee. 70. When evaluating the severity of a deficiency, or combination of deficiencies, the auditor also should determine the level of detail and degree of assurance that would satisfy prudent officials in the conduct of their own affairs that they have reasonable assurance that transactions are recorded as necessary to permit the preparation of financial statements in conformity with generally accepted accounting principles. If the auditor determines that a deficiency, or combination of deficiencies, might prevent prudent officials in the conduct of their own affairs from concluding that they have reasonable assurance that transactions are recorded as necessary to permit the preparation of financial statements in conformity with generally accepted accounting principles, then the auditor should treat the deficiency, or combination of deficiencies, as an indicator of a material weakness. Wrapping-Up Forming an Opinion 71. The auditor should form an opinion on the effectiveness of internal control over financial reporting by evaluating evidence obtained from all sources, including the auditor's testing of controls, misstatements detected during the financial statement audit, and any identified control deficiencies. Note: As part of this evaluation, the auditor should review reports issued during the year by internal audit (or similar functions) that address controls related to internal control over financial reporting and evaluate control deficiencies identified in those reports. 72. After forming an opinion on the effectiveness of the company's internal control over financial reporting, the auditor should evaluate the presentation of the elements that management is required, under the SEC's rules, to present in its annual report on internal control over financial reporting. 16 16 *See* Item 308(a) of Regulations S-B and S-K, 17 CFR 228.308(a) and 229.308(a). 73. If the auditor determines that any required elements of management's annual report on internal control over financial reporting are incomplete or improperly presented, the auditor should follow the direction in paragraph C2. 74. The auditor may form an opinion on the effectiveness of internal control over financial reporting only when there have been no restrictions on the scope of the auditor's work. A scope limitation requires the auditor to disclaim an opinion or withdraw from the engagement (see paragraphs C3 through C7). Obtaining Written Representations 75. In an audit of internal control over financial reporting, the auditor should obtain written representations from management— a. Acknowledging management's responsibility for establishing and maintaining effective internal control over financial reporting; b. Stating that management has performed an evaluation and made an assessment of the effectiveness of the company's internal control over financial reporting and specifying the control criteria; c. Stating that management did not use the auditor's procedures performed during the audits of internal control over financial reporting or the financial statements as part of the basis for management's assessment of the effectiveness of internal control over financial reporting; d. Stating management's conclusion, as set forth in its assessment, about the effectiveness of the company's internal control over financial reporting based on the control criteria as of a specified date; e. Stating that management has disclosed to the auditor all deficiencies in the design or operation of internal control over financial reporting identified as part of management's evaluation, including separately disclosing to the auditor all such deficiencies that it believes to be significant deficiencies or material weaknesses in internal control over financial reporting; f. Describing any fraud resulting in a material misstatement to the company's financial statements and any other fraud that does not result in a material misstatement to the company's financial statements but involves senior management or management or other employees who have a significant role in the company's internal control over financial reporting; g. Stating whether control deficiencies identified and communicated to the audit committee during previous engagements pursuant to paragraphs 77 and 79 have been resolved, * and specifically identifying any that have not; and * PCAOB staff have told the Commission staff that the references to paragraphs 77 and 79 in paragraph 75.g. of the proposed rule should instead refer to paragraphs 78 and 80, and that this typographical error will be corrected. Telephone conversation between Sharon Virag, Associate Chief Auditor, PCAOB, and Brian Croteau, Associate Chief Accountant, SEC, on June 4, 2007. h. Stating whether there were, subsequent to the date being reported on, any changes in internal control over financial reporting or other factors that might significantly affect internal control over financial reporting, including any corrective actions taken by management with regard to significant deficiencies and material weaknesses. 76. The failure to obtain written representations from management, including management's refusal to furnish them, constitutes a limitation on the scope of the audit. As discussed further in paragraph C3, when the scope of the audit is limited, the auditor should either withdraw from the engagement or disclaim an opinion. Further, the auditor should evaluate the effects of management's refusal on his or her ability to rely on other representations, including those obtained in the audit of the company's financial statements. 77. AU sec. 333, *Management Representations* , explains matters such as who should sign the letter, the period to be covered by the letter, and when to obtain an updated letter. Communicating Certain Matters 78. The auditor must communicate, in writing, to management and the audit committee all material weaknesses identified during the audit. The written communication should be made prior to the issuance of the auditor's report on internal control over financial reporting. 79. If the auditor concludes that the oversight of the company's external financial reporting and internal control over financial reporting by the company's audit committee is ineffective, the auditor must communicate that conclusion in writing to the board of directors. 80. The auditor also should consider whether there are any deficiencies, or combinations of deficiencies, that have been identified during the audit that are significant deficiencies and must communicate such deficiencies, in writing, to the audit committee. 81. The auditor also should communicate to management, in writing, all deficiencies in internal control over financial reporting ( *i.e.* , those deficiencies in internal control over financial reporting that are of a lesser magnitude than material weaknesses) identified during the audit and inform the audit committee when such a communication has been made. When making this communication, it is not necessary for the auditor to repeat information about such deficiencies that has been included in previously issued written communications, whether those communications were made by the auditor, internal auditors, or others within the organization. 82. The auditor is not required to perform procedures that are sufficient to identify all control deficiencies; rather, the auditor communicates deficiencies in internal control over financial reporting of which he or she is aware. 83. Because the audit of internal control over financial reporting does not provide the auditor with assurance that he or she has identified all deficiencies less severe than a material weakness, the auditor should not issue a report stating that no such deficiencies were noted during the audit. 84. When auditing internal control over financial reporting, the auditor may become aware of fraud or possible illegal acts. In such circumstances, the auditor must determine his or her responsibilities under AU sec. 316, *Consideration of Fraud in a Financial Statement Audit* , AU sec. 317, *Illegal Acts by Clients* , and Section 10A of the Securities Exchange Act of 1934. 17 17 *See* 15 U.S.C. 78j-1. Reporting on Internal Control 85. The auditor's report on the audit of internal control over financial reporting must include the following elements 18 — 18 *See* Appendix C, which provides direction on modifications to the author's report that are required in certain circumstances. a. A title that includes the word *independent* ; b. A statement that management is responsible for maintaining effective internal control over financial reporting and for assessing the effectiveness of internal control over financial reporting; c. An identification of management's report on internal control; d. A statement that the auditor's responsibility is to express an opinion on the company's internal control over financial reporting based on his or her audit; e. A definition of internal control over financial reporting as stated in paragraph A5; f. A statement that the audit was conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States); g. A statement that the standards of the Public Company Accounting Oversight Board require that the auditor plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects; h. A statement that an audit includes obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as the auditor considered necessary in the circumstances; i. A statement that the auditor believes the audit provides a reasonable basis for his or her opinion; j. A paragraph stating that, because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements and that projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate; k. The auditor's opinion on whether the company maintained, in all material respects, effective internal control over financial reporting as of the specified date, based on the control criteria; l. The manual or printed signature of the auditor's firm; m. The city and state (or city and country, in the case of non-U.S. auditors) from which the auditor's report has been issued; and n. The date of the audit report. Separate or Combined Reports 86. The auditor may choose to issue a combined report ( *i.e.* , one report containing both an opinion on the financial statements and an opinion on internal control over financial reporting) or separate reports on the company's financial statements and on internal control over financial reporting. 87. The following example combined report expressing an unqualified opinion on financial statements and an unqualified opinion on internal control over financial reporting illustrates the report elements described in this section. Report of Independent Registered Public Accounting Firm [Introductory paragraph] We have audited the accompanying balance sheets of W Company as of December 31, 20X8 and 20X7, and the related statements of income, stockholders' equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 20X8. We also have audited W Company's internal control over financial reporting as of December 31, 20X8, based on [I *dentify control criteria, for example, “criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).”* ]. W Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying [title of management's report]. Our responsibility is to express an opinion on these financial statements and an opinion on the company's internal control over financial reporting based on our audits. [Scope paragraph] We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. [Definition paragraph] A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that
(1)Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;
(2)provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
(3)provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. [Inherent limitations paragraph] Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. [Opinion paragraph] In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of W Company as of December 31, 20X8 and 20X7, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 20X8 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, W Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 20X8, based on [ *Identify control criteria, for example, “criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).”* ]. [ *Signature* ] [ *City and State or Country* ] [ *Date* ] 88. If the auditor chooses to issue a separate report on internal control over financial reporting, he or she should add the following paragraph to the auditor's report on the financial statements— We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), W Company's internal control over financial reporting as of December 31, 20X8, based on [ *identify control criteria* ] and our report dated *[date of report, which should be the same as the date of the report on the financial statements* ] expressed [ *include nature of opinion* ]. The auditor also should add the following paragraph to the report on internal control over financial reporting— We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the [ *identify financial statements* ] of W Company and our report dated [ *date of report, which should be the same as the date of the report on the effectiveness of internal control over financial reporting* ] expressed [ *include nature of opinion* ]. Report Date 89. The auditor should date the audit report no earlier than the date on which the auditor has obtained sufficient competent evidence to support the auditor's opinion. Because the auditor cannot audit internal control over financial reporting without also auditing the financial statements, the reports should be dated the same. Material Weaknesses 90. Paragraphs 62 through 70 describe the evaluation of deficiencies. If there are deficiencies that, individually or in combination, result in one or more material weaknesses, the auditor must express an adverse opinion on the company's internal control over financial reporting, unless there is a restriction on the scope of the engagement. 19 19 *See* paragraph C3 for direction when the scope of the engagement has been limited. 91. When expressing an adverse opinion on internal control over financial reporting because of a material weakness, the auditor's report must include— • The definition of a material weakness, as provided in paragraph A7. • A statement that a material weakness has been identified and an identification of the material weakness described in management's assessment. Note: If the material weakness has not been included in management's assessment, the report should be modified to state that a material weakness has been identified but not included in management's assessment. Additionally, the auditor's report should include a description of the material weakness, which should provide the users of the audit report with specific information about the nature of the material weakness and its actual and potential effect on the presentation of the company's financial statements issued during the existence of the weakness. In this case, the auditor also should communicate in writing to the audit committee that the material weakness was not disclosed or identified as a material weakness in management's assessment. If the material weakness has been included in management's assessment but the auditor concludes that the disclosure of the material weakness is not fairly presented in all material respects, the auditor's report should describe this conclusion as well as the information necessary to fairly describe the material weakness. 92. The auditor should determine the effect his or her adverse opinion on internal control has on his or her opinion on the financial statements. Additionally, the auditor should disclose whether his or her opinion on the financial statements was affected by the adverse opinion on internal control over financial reporting. Note: If the auditor issues a separate report on internal control over financial reporting in this circumstance, the disclosure required by this paragraph may be combined with the report language described in paragraphs 88 and 91. The auditor may present the combined language either as a separate paragraph or as part of the paragraph that identifies the material weakness. Subsequent Events 93. Changes in internal control over financial reporting or other factors that might significantly affect internal control over financial reporting might occur subsequent to the date as of which internal control over financial reporting is being audited but before the date of the auditor's report. The auditor should inquire of management whether there were any such changes or factors and obtain written representations from management relating to such matters, as described in paragraph 75h. 94. To obtain additional information about whether changes have occurred that might affect the effectiveness of the company's internal control over financial reporting and, therefore, the auditor's report, the auditor should inquire about and examine, for this subsequent period, the following— • Relevant internal audit (or similar functions, such as loan review in a financial institution) reports issued during the subsequent period, • Independent auditor reports (if other than the auditor's) of deficiencies in internal control, • Regulatory agency reports on the company's internal control over financial reporting, and • Information about the effectiveness of the company's internal control over financial reporting obtained through other engagements. 95. The auditor might inquire about and examine other documents for the subsequent period. Paragraphs .01 through .09 of AU sec. 560, *Subsequent Events* , provide direction on subsequent events for a financial statement audit that also may be helpful to the auditor performing an audit of internal control over financial reporting. 96. If the auditor obtains knowledge about subsequent events that materially and adversely affect the effectiveness of the company's internal control over financial reporting as of the date specified in the assessment, the auditor should issue an adverse opinion on internal control over financial reporting (and follow the direction in paragraph C2 if management's assessment states that internal control over financial reporting is effective). If the auditor is unable to determine the effect of the subsequent event on the effectiveness of the company's internal control over financial reporting, the auditor should disclaim an opinion. As described in paragraph C13, the auditor should disclaim an opinion on management's disclosures about corrective actions taken by the company after the date of management's assessment, if any. 97. The auditor may obtain knowledge about subsequent events with respect to conditions that did not exist at the date specified in the assessment but arose subsequent to that date and before issuance of the auditor's report. If a subsequent event of this type has a material effect on the company's internal control over financial reporting, the auditor should include in his or her report an explanatory paragraph describing the event and its effects or directing the reader's attention to the event and its effects as disclosed in management's report. 98. After the issuance of the report on internal control over financial reporting, the auditor may become aware of conditions that existed at the report date that might have affected the auditor's opinion had he or she been aware of them. The auditor's evaluation of such subsequent information is similar to the auditor's evaluation of information discovered subsequent to the date of the report on an audit of financial statements, as described in AU sec. 561, *Subsequent Discovery of Facts Existing at the Date of the Auditor's Report* . Appendix A—Definitions A1. For purposes of this standard, the terms listed below are defined as follows— A2. A *control objective* provides a specific target against which to evaluate the effectiveness of controls. A control objective for internal control over financial reporting generally relates to a relevant assertion and states a criterion for evaluating whether the company's control procedures in a specific area provide reasonable assurance that a misstatement or omission in that relevant assertion is prevented or detected by controls on a timely basis. A3. A *deficiency* in internal control over financial reporting exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis. • A deficiency in *design* exists when
(a)A control necessary to meet the control objective is missing or
(b)an existing control is not properly designed so that, even if the control operates as designed, the control objective would not be met. • A deficiency in *operation* exists when a properly designed control does not operate as designed, or when the person performing the control does not possess the necessary authority or competence to perform the control effectively. A4. *Financial statements and related disclosures* refers to a company's financial statements and notes to the financial statements as presented in accordance with generally accepted accounting principles (“GAAP”). References to financial statements and related disclosures do not extend to the preparation of management's discussion and analysis or other similar financial information presented outside a company's GAAP-basis financial statements and notes. A5. *Internal control over financial reporting* is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP and includes those policies and procedures that—
(1)Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;
(2)Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
(3)Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. 1 1 *See* Securities Exchange Act Rules 13a-15(f) and 15d-15(f), 17 CFR 240.13a-15(f) and 240.15d-15(f). Note: The auditor's procedures as part of either the audit of internal control over financial reporting or the audit of the financial statements are not part of a company's internal control over financial reporting. Note: Internal control over financial reporting has inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements will not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk. A6. *Management's assessment* is the assessment described in Item 308(a)(3) of Regulations S-B and S-K that is included in management's annual report on internal control over financial reporting. 2 2 *See* 17 CFR 228.308(a)(3) and 229.308(a)(3). A7. A *material weakness* is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a *reasonable possibility* that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. Note: There is a *reasonable possibility* of an event, as used in this standard, when the likelihood of the event is either “reasonably possible” or “probable,” as those terms are used in Financial Accounting Standards Board Statement No. 5, *Accounting for Contingencies* (“FAS 5”). 3 3 *See* FAS 5, paragraph 3. A8. Controls over financial reporting may be *preventive controls* or *detective controls* . Effective internal control over financial reporting often includes a combination of preventive and detective controls. • Preventive controls have the objective of preventing errors or fraud that could result in a misstatement of the financial statements from occurring. • Detective controls have the objective of detecting errors or fraud that has already occurred that could result in a misstatement of the financial statements. A9. A *relevant assertion* is a financial statement assertion that has a reasonable possibility of containing a misstatement or misstatements that would cause the financial statements to be materially misstated. The determination of whether an assertion is a relevant assertion is based on inherent risk, without regard to the effect of controls. A10. An account or disclosure is a *significant account or disclosure* if there is a reasonable possibility that the account or disclosure could contain a misstatement that, individually or when aggregated with others, has a material effect on the financial statements, considering the risks of both overstatement and understatement. The determination of whether an account or disclosure is significant is based on inherent risk, without regard to the effect of controls. A11. A *significant deficiency* is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company's financial reporting. Appendix B—Special Topics Integration of Audits B1. *Tests of Controls in an Audit of Internal Control.* The objective of the tests of controls in an audit of internal control over financial reporting is to obtain evidence about the effectiveness of controls to support the auditor's opinion on the company's internal control over financial reporting. The auditor's opinion relates to the effectiveness of the company's internal control over financial reporting as of a *point in time and taken as a whole* . B2. To express an opinion on internal control over financial reporting as of a point in time, the auditor should obtain evidence that internal control over financial reporting has operated effectively for a sufficient period of time, which may be less than the entire period (ordinarily one year) covered by the company's financial statements. To express an opinion on internal control over financial reporting taken as a whole, the auditor must obtain evidence about the effectiveness of selected controls over all relevant assertions. This requires that the auditor test the design and operating effectiveness of controls he or she ordinarily would not test if expressing an opinion only on the financial statements. B3. When concluding on the effectiveness of internal control over financial reporting for purposes of expressing an opinion on internal control over financial reporting, the auditor should incorporate the results of any additional tests of controls performed to achieve the objective related to expressing an opinion on the financial statements, as discussed in the following section. B4. *Tests of Controls in an Audit of Financial Statements.* To express an opinion on the financial statements, the auditor ordinarily performs tests of controls and substantive procedures. The objective of the tests of controls the auditor performs for this purpose is to assess control risk. To assess control risk for specific financial statement assertions at less than the maximum, the auditor is required to obtain evidence that the relevant controls operated effectively during the *entire period* upon which the auditor plans to place reliance on those controls. However, the auditor is not required to assess control risk at less than the maximum for *all* relevant assertions and, for a variety of reasons, the auditor may choose not to do so. B5. When concluding on the effectiveness of controls for the purpose of assessing control risk, the auditor also should evaluate the results of any additional tests of controls performed to achieve the objective related to expressing an opinion on the company's internal control over financial reporting, as discussed in paragraph B2. Consideration of these results may require the auditor to alter the nature, timing, and extent of substantive procedures and to plan and perform further tests of controls, particularly in response to identified control deficiencies. B6. *Effect of Tests of Controls on Substantive Procedures.* If, during the audit of internal control over financial reporting, the auditor identifies a deficiency, he or she should determine the effect of the deficiency, if any, on the nature, timing, and extent of substantive procedures to be performed to reduce audit risk in the audit of the financial statements to an appropriately low level. B7. Regardless of the assessed level of control risk or the assessed risk of material misstatement in connection with the audit of the financial statements, the auditor should perform substantive procedures for all relevant assertions. Performing procedures to express an opinion on internal control over financial reporting does not diminish this requirement. B8. *Effect of Substantive Procedures on the Auditor's Conclusions About the Operating Effectiveness of Controls.* In an audit of internal control over financial reporting, the auditor should evaluate the effect of the findings of the substantive auditing procedures performed in the audit of financial statements on the effectiveness of internal control over financial reporting. This evaluation should include, at a minimum— • The auditor's risk assessments in connection with the selection and application of substantive procedures, especially those related to fraud. • Findings with respect to illegal acts and related party transactions. • Indications of management bias in making accounting estimates and in selecting accounting principles. • Misstatements detected by substantive procedures. The extent of such misstatements might alter the auditor's judgment about the effectiveness of controls. B9. To obtain evidence about whether a selected control is effective, the control must be tested directly; the effectiveness of a control cannot be inferred from the absence of misstatements detected by substantive procedures. The absence of misstatements detected by substantive procedures, however, should inform the auditor's risk assessments in determining the testing necessary to conclude on the effectiveness of a control. Multiple Locations Scoping Decisions B10. In determining the locations or business units at which to perform tests of controls, the auditor should assess the risk of material misstatement to the financial statements associated with the location or business unit and correlate the amount of audit attention devoted to the location or business unit with the degree of risk. Note: The auditor may eliminate from further consideration locations or business units that, individually or when aggregated with others, do not present a reasonable possibility of material misstatement to the company's consolidated financial statements. B11. In assessing and responding to risk, the auditor should test controls over specific risks that present a reasonable possibility of material misstatement to the company's consolidated financial statements. In lower-risk locations or business units, the auditor first might evaluate whether testing entity-level controls, including controls in place to provide assurance that appropriate controls exist throughout the organization, provides the auditor with sufficient evidence. B12. In determining the locations or business units at which to perform tests of controls, the auditor may take into account work performed by others on behalf of management. For example, if the internal auditors' planned procedures include relevant audit work at various locations, the auditor may coordinate work with the internal auditors and reduce the number of locations or business units at which the auditor would otherwise need to perform auditing procedures. B13. The direction in paragraph 61 regarding special considerations for subsequent years' audits means that the auditor should vary the nature, timing, and extent of testing of controls at locations or business units from year to year. B14. *Special Situations.* The scope of the audit should include entities that are acquired on or before the date of management's assessment and operations that are accounted for as discontinued operations on the date of management's assessment. The direction in this multiple-locations discussion describes how to determine whether it is necessary to test controls at these entities or operations. B15. For equity method investments, the scope of the audit should include controls over the reporting in accordance with generally accepted accounting principles, in the company's financial statements, of the company's portion of the investees' income or loss, the investment balance, adjustments to the income or loss and investment balance, and related disclosures. The audit ordinarily would not extend to controls at the equity method investee. B16. In situations in which the SEC allows management to limit its assessment of internal control over financial reporting by excluding certain entities, the auditor may limit the audit in the same manner. In these situations, the auditor's opinion would not be affected by a scope limitation. However, the auditor should include, either in an additional explanatory paragraph or as part of the scope paragraph in his or her report, a disclosure similar to management's regarding the exclusion of an entity from the scope of both management's assessment and the auditor's audit of internal control over financial reporting. Additionally, the auditor should evaluate the reasonableness of management's conclusion that the situation meets the criteria of the SEC's allowed exclusion and the appropriateness of any required disclosure related to such a limitation. If the auditor believes that management's disclosure about the limitation requires modification, the auditor should follow the same communication responsibilities that are described in paragraphs .29 through .32 of AU sec. 722, *Interim Financial Information.* If management and the audit committee do not respond appropriately, in addition to fulfilling those responsibilities, the auditor should modify his or her report on the audit of internal control over financial reporting to include an explanatory paragraph describing the reasons why the auditor believes management's disclosure requires modification. Use of Service Organizations B17. AU sec. 324, *Service Organizations,* applies to the audit of financial statements of a company that obtains services from another organization that are part of the company's information system. The auditor may apply the relevant concepts described in AU sec. 324 to the audit of internal control over financial reporting. B18. AU sec. 324.03 describes the situation in which a service organization's services are part of a company's information system. If the service organization's services are part of a company's information system, as described therein, then they are part of the information and communication component of the company's internal control over financial reporting. When the service organization's services are part of the company's internal control over financial reporting, the auditor should include the activities of the service organization when determining the evidence required to support his or her opinion. B19. AU sec. 324.07 through .16 describe the procedures that the auditor should perform with respect to the activities performed by the service organization. The procedures include— a. Obtaining an understanding of the controls at the service organization that are relevant to the entity's internal control and the controls at the user organization over the activities of the service organization, and b. Obtaining evidence that the controls that are relevant to the auditor's opinion are operating effectively. B20. Evidence that the controls that are relevant to the auditor's opinion are operating effectively may be obtained by following the procedures described in AU sec. 324.12. These procedures include— a. Obtaining a service auditor's report on controls placed in operation and tests of operating effectiveness, or a report on the application of agreed-upon procedures that describes relevant tests of controls. Note: The service auditor's report referred to above means a report with the service auditor's opinion on the service organization's description of the design of its controls, the tests of controls, and results of those tests performed by the service auditor, and the service auditor's opinion on whether the controls tested were operating effectively during the specified period (in other words, “reports on controls placed in operation and tests of operating effectiveness” described in AU sec. 324.24b). A service auditor's report that does not include tests of controls, results of the tests, and the service auditor's opinion on operating effectiveness (in other words, “reports on controls placed in operation” described in AU sec. 324.24a) does not provide evidence of operating effectiveness. Furthermore, if the evidence regarding operating effectiveness of controls comes from an agreed-upon procedures report rather than a service auditor's report issued pursuant to AU sec. 324, the auditor should evaluate whether the agreed-upon procedures report provides sufficient evidence in the same manner described in the following paragraph. b. Performing tests of the user organization's controls over the activities of the service organization ( *e.g.* , testing the user organization's independent re-performance of selected items processed by the service organization or testing the user organization's reconciliation of output reports with source documents). c. Performing tests of controls at the service organization. B21. If a service auditor's report on controls placed in operation and tests of operating effectiveness is available, the auditor may evaluate whether this report provides sufficient evidence to support his or her opinion. In evaluating whether such a service auditor's report provides sufficient evidence, the auditor should assess the following factors— • The time period covered by the tests of controls and its relation to the as-of date of management's assessment, • The scope of the examination and applications covered, the controls tested, and the way in which tested controls relate to the company's controls, and • The results of those tests of controls and the service auditor's opinion on the operating effectiveness of the controls. Note: These factors are similar to factors the auditor would consider in determining whether the report provides sufficient evidence to support the auditor's assessed level of control risk in an audit of the financial statements, as described in AU sec. 324.16. B22. If the service auditor's report on controls placed in operation and tests of operating effectiveness contains a qualification that the stated control objectives might be achieved only if the company applies controls contemplated in the design of the system by the service organization, the auditor should evaluate whether the company is applying the necessary procedures. B23. In determining whether the service auditor's report provides sufficient evidence to support the auditor's opinion, the auditor should make inquiries concerning the service auditor's reputation, competence, and independence. Appropriate sources of information concerning the professional reputation of the service auditor are discussed in paragraph .10a of AU sec. 543, *Part of Audit Performed by Other Independent Auditors.* B24. When a significant period of time has elapsed between the time period covered by the tests of controls in the service auditor's report and the date specified in management's assessment, additional procedures should be performed. The auditor should inquire of management to determine whether management has identified any changes in the service organization's controls subsequent to the period covered by the service auditor's report (such as changes communicated to management from the service organization, changes in personnel at the service organization with whom management interacts, changes in reports or other data received from the service organization, changes in contracts or service level agreements with the service organization, or errors identified in the service organization's processing). If management has identified such changes, the auditor should evaluate the effect of such changes on the effectiveness of the company's internal control over financial reporting. The auditor also should evaluate whether the results of other procedures he or she performed indicate that there have been changes in the controls at the service organization. B25. The auditor should determine whether to obtain additional evidence about the operating effectiveness of controls at the service organization based on the procedures performed by management or the auditor and the results of those procedures and on an evaluation of the following risk factors. As risk increases, the need for the auditor to obtain additional evidence increases. • The elapsed time between the time period covered by the tests of controls in the service auditor's report and the date specified in management's assessment, • The significance of the activities of the service organization, • Whether there are errors that have been identified in the service organization's processing, and • The nature and significance of any changes in the service organization's controls identified by management or the auditor. B26. If the auditor concludes that additional evidence about the operating effectiveness of controls at the service organization is required, the auditor's additional procedures might include— • Evaluating procedures performed by management and the results of those procedures. • Contacting the service organization, through the user organization, to obtain specific information. • Requesting that a service auditor be engaged to perform procedures that will supply the necessary information. • Visiting the service organization and performing such procedures. B27. The auditor should not refer to the service auditor's report when expressing an opinion on internal control over financial reporting. Benchmarking of Automated Controls B28. Entirely automated application controls are generally not subject to breakdowns due to human failure. This feature allows the auditor to use a “benchmarking” strategy. B29. If general controls over program changes, access to programs, and computer operations are effective and continue to be tested, and if the auditor verifies that the automated application control has not changed since the auditor established a baseline ( *i.e.* , last tested the application control), the auditor may conclude that the automated application control continues to be effective without repeating the prior year's specific tests of the operation of the automated application control. The nature and extent of the evidence that the auditor should obtain to verify that the control has not changed may vary depending on the circumstances, including depending on the strength of the company's program change controls. B30. The consistent and effective functioning of the automated application controls may be dependent upon the related files, tables, data, and parameters. For example, an automated application for calculating interest income might be dependent on the continued integrity of a rate table used by the automated calculation. B31. To determine whether to use a benchmarking strategy, the auditor should assess the following risk factors. As these factors indicate lower risk, the control being evaluated might be well-suited for benchmarking. As these factors indicate increased risk, the control being evaluated is less suited for benchmarking. These factors are— • The extent to which the application control can be matched to a defined program within an application. • The extent to which the application is stable ( *i.e.* , there are few changes from period to period). • The availability and reliability of a report of the compilation dates of the programs placed in production. (This information may be used as evidence that controls within the program have not changed.) B32. Benchmarking automated application controls can be especially effective for companies using purchased software when the possibility of program changes is remote— *e.g.* , when the vendor does not allow access or modification to the source code. B33. After a period of time, the length of which depends upon the circumstances, the baseline of the operation of an automated application control should be reestablished. To determine when to reestablish a baseline, the auditor should evaluate the following factors— • The effectiveness of the IT control environment, including controls over application and system software acquisition and maintenance, access controls and computer operations. • The auditor's understanding of the nature of changes, if any, on the specific programs that contain the controls. • The nature and timing of other related tests. • The consequences of errors associated with the application control that was benchmarked. • Whether the control is sensitive to other business factors that may have changed. For example, an automated control may have been designed with the assumption that only positive amounts will exist in a file. Such a control would no longer be effective if negative amounts (credits) begin to be posted to the account. Appendix C—Special Reporting Situations Report Modifications C1. The auditor should modify his or her report if any of the following conditions exist. a. Elements of management's annual report on internal control are incomplete or improperly presented, b. There is a restriction on the scope of the engagement, c. The auditor decides to refer to the report of other auditors as the basis, in part, for the auditor's own report, d. There is other information contained in management's annual report on internal control over financial reporting, or e. Management's annual certification pursuant to Section 302 of the Sarbanes-Oxley Act is misstated. C2. *Elements of Management's Annual Report on Internal Control Over Financial Reporting Are Incomplete or Improperly Presented.* If the auditor determines that elements of management's annual report on internal control over financial reporting are incomplete or improperly presented, the auditor should modify his or her report to include an explanatory paragraph describing the reasons for this determination. If the auditor determines that the required disclosure about a material weakness is not fairly presented in all material respects, the auditor should follow the direction in paragraph 91. C3. *Scope Limitations.* The auditor can express an opinion on the company's internal control over financial reporting only if the auditor has been able to apply the procedures necessary in the circumstances. If there are restrictions on the scope of the engagement, the auditor should withdraw from the engagement or disclaim an opinion. A disclaimer of opinion states that the auditor does not express an opinion on the effectiveness of internal control over financial reporting. C4. When disclaiming an opinion because of a scope limitation, the auditor should state that the scope of the audit was not sufficient to warrant the expression of an opinion and, in a separate paragraph or paragraphs, the substantive reasons for the disclaimer. The auditor should not identify the procedures that were performed nor include the statements describing the characteristics of an audit of internal control over financial reporting (paragraph 85 g, h, and i); to do so might overshadow the disclaimer. C5. When the auditor plans to disclaim an opinion and the limited procedures performed by the auditor caused the auditor to conclude that a material weakness exists, the auditor's report also should include— • The definition of a material weakness, as provided in paragraph A7. • A description of any material weaknesses identified in the company's internal control over financial reporting. This description should provide the users of the audit report with specific information about the nature of any material weakness and its actual and potential effect on the presentation of the company's financial statements issued during the existence of the weakness. This description also should address the requirements in paragraph 91. C6. The auditor may issue a report disclaiming an opinion on internal control over financial reporting as soon as the auditor concludes that a scope limitation will prevent the auditor from obtaining the reasonable assurance necessary to express an opinion. The auditor is not required to perform any additional work prior to issuing a disclaimer when the auditor concludes that he or she will not be able to obtain sufficient evidence to express an opinion. Note: In this case, in following the direction in paragraph 89 regarding dating the auditor's report, the report date is the date that the auditor has obtained sufficient competent evidence to support the representations in the auditor's report. C7. If the auditor concludes that he or she cannot express an opinion because there has been a limitation on the scope of the audit, the auditor should communicate, in writing, to management and the audit committee that the audit of internal control over financial reporting cannot be satisfactorily completed. C8. *Opinions Based, in Part, on the Report of Another Auditor.* When another auditor has audited the financial statements and internal control over financial reporting of one or more subsidiaries, divisions, branches, or components of the company, the auditor should determine whether he or she may serve as the principal auditor and use the work and reports of another auditor as a basis, in part, for his or her opinion. AU sec. 543, *Part of Audit Performed by Other Independent Auditors,* provides direction on the auditor's decision of whether to serve as the principal auditor of the financial statements. If the auditor decides it is appropriate to serve as the principal auditor of the financial statements, then that auditor also should be the principal auditor of the company's internal control over financial reporting. This relationship results from the requirement that an audit of the financial statements must be performed to audit internal control over financial reporting; only the principal auditor of the financial statements can be the principal auditor of internal control over financial reporting. In this circumstance, the principal auditor of the financial statements must participate sufficiently in the audit of internal control over financial reporting to provide a basis for serving as the principal auditor of internal control over financial reporting. C9. When serving as the principal auditor of internal control over financial reporting, the auditor should decide whether to make reference in the report on internal control over financial reporting to the audit of internal control over financial reporting performed by the other auditor. In these circumstances, the auditor's decision is based on factors analogous to those of the auditor who uses the work and reports of other independent auditors when reporting on a company's financial statements as described in AU sec. 543. C10. The decision about whether to make reference to another auditor in the report on the audit of internal control over financial reporting might differ from the corresponding decision as it relates to the audit of the financial statements. For example, the audit report on the financial statements may make reference to the audit of a significant equity investment performed by another independent auditor, but the report on internal control over financial reporting might not make a similar reference because management's assessment of internal control over financial reporting ordinarily would not extend to controls at the equity method investee. 1 1 *See* paragraph B15, for further discussion of the evaluation of the controls over financial reporting for an equity method investment. C11. When the auditor decides to make reference to the report of the other auditor as a basis, in part, for his or her opinion on the company's internal control over financial reporting, the auditor should refer to the report of the other auditor when describing the scope of the audit and when expressing the opinion. C12. *Management's Annual Report on Internal Control Over Financial Reporting Containing Additional Information.* Management's annual report on internal control over financial reporting may contain information in addition to the elements described in paragraph 72 that are subject to the auditor's evaluation. C13. If management's annual report on internal control over financial reporting could reasonably be viewed by users of the report as including such additional information, the auditor should disclaim an opinion on the information. C14. If the auditor believes that management's additional information contains a material misstatement of fact, he or she should discuss the matter with management. If, after discussing the matter with management, the auditor concludes that a material misstatement of fact remains, the auditor should notify management and the audit committee, in writing, of the auditor's views concerning the information. AU sec. 317, *Illegal Acts by Clients* and Section 10A of the Securities Exchange Act of 1934 may also require the auditor to take additional action. 2 2 *See* 15 U.S.C. 78j-1. Note: If management makes the types of disclosures described in paragraph C12 outside its annual report on internal control over financial reporting and includes them elsewhere within its annual report on the company's financial statements, the auditor would not need to disclaim an opinion. However, in that situation, the auditor's responsibilities are the same as those described in this paragraph if the auditor believes that the additional information contains a material misstatement of fact. C15. *Management's Annual Certification Pursuant to Section 302 of the Sarbanes-Oxley Act is Misstated.* If matters come to the auditor's attention as a result of the audit of internal control over financial reporting that lead him or her to believe that modifications to the disclosures about changes in internal control over financial reporting (addressing changes in internal control over financial reporting occurring during the fourth quarter) are necessary for the annual certifications to be accurate and to comply with the requirements of Section 302 of the Act and Securities Exchange Act Rule 13a-14(a) or 15d-14(a), whichever applies, 3 the auditor should follow the communication responsibilities as described in AU sec. 722 *Interim Financial Information,* for any interim period. However, if management and the audit committee do not respond appropriately, in addition to the responsibilities described in AU sec. 722, the auditor should modify his or her report on the audit of internal control over financial reporting to include an explanatory paragraph describing the reasons the auditor believes management's disclosures should be modified. 3 *See* 17 CFR 240.13a-14(a) and 240.15d-14(a). Filings Under Federal Securities Statutes C16. AU sec. 711, *Filings Under Federal Securities Statutes,* describes the auditor's responsibilities when an auditor's report is included in registration statements, proxy statements, or periodic reports filed under the federal securities statutes. The auditor should apply AU sec. 711 with respect to the auditor's report on internal control over financial reporting included in such filings. In addition, the auditor should extend the direction in AU sec. 711.10 to inquire of and obtain written representations from officers and other executives responsible for financial and accounting matters about whether any events have occurred that have a material effect on the audited financial statements to matters that could have a material effect on internal control over financial reporting. C17. When the auditor has fulfilled these responsibilities and intends to consent to the inclusion of his or her report on internal control over financial reporting in the securities filing, the auditor's consent should clearly indicate that both the audit report on financial statements and the audit report on internal control over financial reporting (or both opinions if a combined report is issued) are included in his or her consent. Rule 3525: Audit Committee Pre-Approval of Non-Audit Services Related to Internal Control Over Financial Reporting In connection with seeking audit committee pre-approval to perform for an audit client any permissible non-audit service related to internal control over financial reporting, a registered public accounting firm shall—
(a)Describe, in writing, to the audit committee of the issuer the scope of the service;
(b)Discuss with the audit committee of the issuer the potential effects of the service on the independence of the firm; and Note: Independence requirements provide that an auditor is not independent of his or her audit client if the auditor is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the auditor is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant's engagement. Several principles guide the application of this general standard, including whether the auditor assumes a management role or audits his or her own work. Therefore, an auditor would not be independent if, for example, management had delegated its responsibility for internal control over financial reporting to the auditor or if the auditor had designed or implemented the audit client's internal control over financial reporting.
(c)Document the substance of its discussion with the audit committee of the issuer. Conforming Amendments to PCAOB Auditing Standards AU sec. 230, “Due Professional Care in the Performance of Work” Statement on Auditing Standards (“SAS”) No. 1, “Codification of Auditing Standards and Procedures,” section 230, “Due Professional Care in the Performance of Work” (AU sec. 230, “Due Professional Care in the Performance of Work”), as amended, is amended as follows— a. Paragraph .10 is replaced with— The exercise of due professional care allows the auditor to obtain *reasonable assurance* about whether the financial statements are free of material misstatement, whether caused by error or fraud, or whether any material weaknesses exist as of the date of management's assessment. Absolute assurance is not attainable because of the nature of audit evidence and the characteristics of fraud. Although not absolute assurance, reasonable assurance is a high level of assurance. Therefore, an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States) may not detect a material weakness in internal control over financial reporting or a material misstatement to the financial statements. b. The term “financial statements” within the first sentence of paragraph .13 is replaced with the term “financial statements or internal control over financial reporting.” c. The second sentence of paragraph .13 is replaced with— Therefore, the subsequent discovery that either a material misstatement, whether from error or fraud, exists in the financial statements or a material weakness in internal control over financial reporting exists does not, in and of itself, evidence
(a)Failure to obtain reasonable assurance,
(b)inadequate planning, performance, or judgment,
(c)the absence of due professional care, or
(d)a failure to comply with the standards of the Public Company Accounting Oversight Board (United States). AU sec. 310, “Appointment of the Independent Auditor” SAS No. 1, “Codification of Auditing Standards and Procedures,” section 310, “Appointment of the Independent Auditor” (AU sec. 310, “Appointment of the Independent Auditor”), as amended, is amended as follows— a. The third bullet point of paragraph .06 is replaced with— Management is responsible for establishing and maintaining effective internal control over financial reporting. If, in an integrated audit of financial statements and internal control over financial reporting, the auditor concludes that he or she cannot express an opinion on internal control over financial reporting because there has been a limitation on the scope of the audit, he or she should communicate, in writing, to management and the audit committee that the audit of internal control over financial reporting cannot be satisfactorily completed. b. The eighth bullet point of paragraph .06 is amended as follows— Under *Integrated audit of financial statements and internal control over financial reporting* , the last sub-bullet point is replaced with the following— To the board of directors—any conclusion that the audit committee's oversight of the company's external financial reporting and internal control over financial reporting is ineffective. Under *Audit of financial statements* , the last sub-bullet is replaced with the following— To the board of directors—if the auditor becomes aware that the oversight of the company's external financial reporting and internal control over financial reporting by the audit committee is ineffective, that conclusion. AU sec. 311, “Planning and Supervision” SAS No. 22, “Planning and Supervision” (AU sec. 311, “Planning and Supervision”), as amended, is amended as follows— Within the note to paragraph 1, the reference to paragraph 39 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraph 9 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . AU sec. 312, “Audit Risk and Materiality in Conducting an Audit” SAS No. 47, “Audit Risk and Materiality in Conducting an Audit” (AU sec. 312, “Audit Risk and Materiality in Conducting an Audit”), as amended, is amended as follows— a. Within the note to paragraph 3, the reference to paragraphs 22-23 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraph 20 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . b. Within the note to paragraph 7, the reference to paragraphs 24-26 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs 14-15 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . c. The note to paragraph 12 is replaced with— Note: When performing an integrated audit of financial statements and internal control over financial reporting, refer to paragraphs 9 and 20 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* , regarding planning considerations and materiality, respectively. d. Within the note to paragraph 18, the reference to Appendix B, *Additional Performance Requirements and Directions; Extent-of-Testing Examples* of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs B10-B16 of Appendix B, *Special Topics* , of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . e. Within the note to paragraph 30, the reference to paragraphs 147-149 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs 6-8 and paragraphs B1-B5 of Appendix B, *Special Topics* , of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . AU sec. 313, “Substantive Tests Prior to the Balance-Sheet Date” SAS No. 45, “Omnibus Statement on Auditing Standards—1983” (AU sec. 313, “Substantive Tests Prior to the Balance-Sheet Date”), is amended as follows— Within the note to paragraph 1, the reference to paragraphs 98-103 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs 52-53 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . AU sec. 315, “Communications Between Predecessor and Successor Auditors” SAS No. 84, “Communications Between Predecessor and Successor Auditors” (AU sec. 315, “Communications Between Predecessor and Successor Auditors”), as amended, is amended as follows— The last sentence of paragraph 16 is replaced with— Furthermore, the predecessor auditor is not a specialist as defined in AU sec. 336, *Using the Work of a Specialist* , nor does the predecessor auditor's work constitute the work of others as described in AU sec. 322, *The Auditor's Consideration of the Internal Audit Function in an Audit of Financial Statements* , or paragraphs 16-19 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . AU sec. 316, “Consideration of Fraud in a Financial Statement Audit” SAS No. 99, “Consideration of Fraud in a Financial Statement Audit” (AU sec. 316, “Consideration of Fraud in a Financial Statement Audit”), is amended as follows— Within the note to paragraph 1, the reference to paragraphs 24-26 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs 14-15 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . AU sec. 319, “Consideration of Internal Control in a Financial Statement Audit” SAS No. 55, “Consideration of Internal Control in a Financial Statement Audit” (AU sec. 319, “Consideration of Internal Control in a Financial Statement Audit”), as amended, is amended as follows— a. The note to paragraph 2 is replaced with— Note: Refer to paragraph A9 of Appendix A, *Definitions* , of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* for the definition of a relevant assertion and paragraphs 28-33 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* for discussion of identifying relevant assertions. b. Within the note to paragraph 9, the reference to Appendix B, *Additional Performance Requirements and Directions; Extent of Testing Examples* , of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs B10-B16 of Appendix B, *Special Topics* , of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . c. The last sentence of paragraph 33 is deleted. d. The note to paragraph 65 is deleted. e. The note to paragraph 83 is deleted. f. Within the note to paragraph 97, the reference to paragraphs 104-105 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraph 54 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . g. The appendix at paragraph 110 is deleted. AU sec. 322, “The Auditor's Consideration of the Internal Audit Function in an Audit of Financial Statements” SAS No. 65, “The Auditor's Consideration of the Internal Audit Function in an Audit of Financial Statements” (AU sec. 322, “The Auditor's Consideration of the Internal Audit Function in an Audit of Financial Statements”), is amended as follows— a. Within the note to paragraph 1, the reference to paragraphs 108-126 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs 16-19 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . b. The note to paragraph 20 is deleted. c. Within the note to paragraph 22, the reference to paragraph 122 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs 18-19 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . AU sec. 324, “Service Organizations” SAS No. 70, “Service Organizations” (AU sec. 324, “Service Organizations”), as amended, is amended as follows— Within the note to paragraph 1, the reference to Appendix B, *Additional Performance Requirements and Directions; Extent-of-Testing Examples* , of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs B17-B27 of Appendix B, *Special Topics* , of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . AU sec. 325, “Communications About Control Deficiencies in an Audit of Financial Statements” 4 4 When the Board adopted Auditing Standard No. 2, it superseded SAS No. 60 in the context of an integrated audit of financial statements and internal control over financial reporting by paragraphs 207-214 of Auditing Standard No. 2. *See* PCAOB Release No. 2004-008, *Conforming Amendments to PCAOB Interim Standards Resulting From the Adoption of PCAOB Auditing Standard No. 2, “An Audit of Internal Control Over Financial Reporting Performed in Conjunction with An Audit of Financial Statements”* (Sept. 15, 2004). As a result of superseding Auditing Standard No. 2, paragraphs 78-84 of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* , now supersede SAS No. 60 in the context of an integrated audit. AU sec. 325, “Communications About Control Deficiencies in an Audit of Financial Statements” is amended as follows— a. The first bullet point before paragraph 1 is amended as follows— The reference to paragraphs 207-214 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs 78-84 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . b. The first bullet point in paragraph 1 is replaced with— A deficiency in design exists when
(a)A control necessary to meet the control objective is missing or
(b)an existing control is not properly designed so that, even if the control operates as designed, the control objective would not be met. c. Paragraph 2 is replaced with— A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting, that is less severe than a material weakness yet important enough to merit attention by those responsible for oversight of the company's financial reporting. d. The notes to paragraph 2 are deleted. e. Paragraph 3 is replaced with— A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. Note: There is a reasonable possibility of an event when the likelihood of the event is either “reasonably possible” or “probable,” as those terms are used in paragraph 3 of Financial Accounting Standards Board Statement No. 5, *Accounting for Contingencies* . Note: In evaluating whether a deficiency exists and whether deficiencies, either individually or in combination with other deficiencies, are material weaknesses, the auditor should follow the direction in paragraphs 62-70 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . f. Paragraph 5 is replaced with— If oversight of the company's external financial reporting and internal control over financial reporting by the company's audit committee is ineffective, that circumstance should be regarded as an indicator that a material weakness in internal control over financial reporting exists. Although there is not an explicit requirement to evaluate the effectiveness of the audit committee's oversight in an audit of only the financial statements, if the auditor becomes aware that the oversight of the company's external financial reporting and internal control over financial reporting by the company's audit committee is ineffective, the auditor must communicate that information in writing to the board of directors. g. The last sentence of paragraph 9 is replaced with— In an audit of financial statements only, auditing interpretation 1 to AU sec. 325, “Reporting on the Existence of Material Weaknesses,” continues to apply except that the term “reportable condition” means “significant deficiency” as defined in paragraph 2 of this standard. AU sec. 9325, “Communication of Internal Control Related Matters Noted in an Audit: Auditing Interpretations of Section 325” AU sec. 9325, “Communication of Internal Control Related Matters Noted in an Audit: Auditing Interpretations of Section 325” is amended as follows— The note prior to paragraph 1 is replaced with— Note: In an audit of financial statements only, auditing interpretation 1 to AU sec. 325, “Reporting on the Existence of Material Weaknesses,” continues to apply except that the term “reportable condition” means “significant deficiency” as defined in paragraph 2 of this standard. Within the example report within paragraph 4 of the interpretation, the third sentence is replaced with the definition of a material weakness in paragraph A7 of Appendix A, *Definitions* , of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . AU sec. 328, “Auditing Fair Value Measurements and Disclosures” SAS No. 101, “Auditing Fair Value Measurements and Disclosures” (AU sec. 328, “Auditing Fair Value Measurements and Disclosures”), is amended as follows— The first sentence of paragraph 41 is replaced with— Events and transactions that occur after the balance-sheet date but before the date of the auditor's report (for example, a sale of an investment shortly after the balance-sheet date), may provide audit evidence regarding management's fair value measurements as of the balance-sheet date 7 7 The auditor's consideration of a subsequent event or transaction, as contemplated in this paragraph, is a substantive test and thus differs from the review of subsequent events performed pursuant to section 560, *Subsequent Events* . AU sec. 332, “Auditing Derivative Instruments, Hedging Activities, and Investments in Securities” SAS No. 92, “Auditing Derivative Instruments, Hedging Activities, and Investments in Securities” (AU sec. 332, “Auditing Derivative Instruments, Hedging Activities, and Investments in Securities”), is amended as follows— The note to paragraph 11 is replaced with— Note: When performing an integrated audit of financial statements and internal control over financial reporting, paragraph 39 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* , states “[t]he auditor should test those controls that are important to the auditor's conclusion about whether the company's controls sufficiently address the assessed risk of misstatement to each relevant assertion.” Therefore, in an integrated audit of financial statements and internal control over financial reporting, if there are relevant assertions related to the company's investment in derivatives and securities, the auditor's understanding of controls should include controls over derivatives and securities transactions from their initiation to their inclusion in the financial statements and should encompass controls placed in operation by the entity and service organizations whose services are part of the entity's information system. AU sec. 333, “Management Representations” SAS No. 85, “Management Representations” (AU sec. 333, “Management Representations”), as amended, is amended as follows— a. Within the note to paragraph 5, the reference to paragraphs 142-144 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs 75-77 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . b. The second sentence of paragraph 9 is replaced with— Because the auditor is concerned with events occurring through the date of his or her report that may require adjustment to or disclosure in the financial statements, the representations should be made as of the date of the auditor's report. AU sec. 9337, “Inquiry of a Client's Lawyer Concerning Litigation, Claims, and Assessments: Auditing Interpretations of Section 337” AU sec. 9337, “Inquiry of a Client's Lawyer Concerning Litigation, Claims, and Assessments: Auditing Interpretations of Section 337” is amended as follows— a. The last sentence of paragraph 4 is replaced with— What is the relationship between the effective date of the lawyer's response and the date of the auditor's report? b. Paragraph 5 is replaced with— *Interpretation* —Section 560.10 through .12 indicates that the auditor is concerned with events, which may require adjustment to, or disclosure in, the financial statements, occurring through the date of his or her report. Therefore, the latest date of the period covered by the lawyer's response (the “effective date”) should be as close to the date of the auditor's report as is practicable in the circumstances. Consequently, specifying the effective date of the lawyer's response to reasonably approximate the expected date of the auditor's report will in most instances obviate the need for an updated response from the lawyer. AU sec. 341, “The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern” SAS No. 59, “The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern” (AU sec. 341, “The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern”), as amended, is amended as follows— The second sentence of paragraph 2 is replaced with— The auditor's evaluation is based on his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor's report. AU sec. 342, “Auditing Accounting Estimates” SAS No. 57, “Auditing Accounting Estimates” (AU sec. 342, “Auditing Accounting Estimates”), is amended as follows— a. Subparagraph c. of paragraph 10 is replaced with— c. Review subsequent events or transactions occurring prior to the date of the auditor's report. b. Paragraph 13 is replaced with— *Review subsequent events or transactions.* Events or transactions sometimes occur subsequent to the date of the balance sheet, but prior to the date of the auditor's report, that are important in identifying and evaluating the reasonableness of accounting estimates or key factors or assumptions used in the preparation of the estimate. In such circumstances, an evaluation of the estimate or of a key factor or assumption may be minimized or unnecessary as the event or transaction can be used by the auditor in evaluating their reasonableness. AU sec. 380, “Communication With Audit Committees” SAS No. 61, “Communication With Audit Committees” (AU sec. 380, “Communication With Audit Committees”), as amended, is amended as follows— Within footnote 1 to paragraph 1, the reference to PCAOB Auditing Standard No. 2 is replaced with a reference to PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . AU sec. 508, “Reports on Audited Financial Statements” SAS No. 58, “Reports on Audited Financial Statements” (AU sec. 508, “Reports on Audited Financial Statements”), as amended, is amended as follows— Within the note to paragraph 1, the reference to paragraphs 162-199 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs 85-98 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* and Appendix C, *Special Reporting Situations* , of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . The sentence that reads “In addition, *see* Appendix A, *Illustrative Reports on Internal Control Over Financial Reporting* , of PCAOB Auditing Standard No. 2, which includes an illustrative combined audit report and examples of separate reports,” is replaced with, “In addition, *see* paragraphs 86-88 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* which includes an illustrative combined audit report.” AU sec. 530, “Dating of the Independent Auditor's Report” SAS No. 1, “Codification of Auditing Standards and Procedures,” section 530, “Dating of the Independent Auditor's Report” (AU sec. 530, “Dating of the Independent Auditor's Report”), as amended, is amended as follows— a. Paragraph .01 is replaced with— The auditor should date the audit report no earlier than the date on which the auditor has obtained sufficient competent evidence to support the auditor's opinion. Paragraph .05 describes the procedure to be followed when a subsequent event occurring after the report date is disclosed in the financial statements. Note: When performing an integrated audit of financial statements and internal control over financial reporting, the auditor's reports on the company's financial statements and on internal control over financial reporting should be dated the same date. Note: If the auditor concludes that a scope limitation will prevent the auditor from obtaining the reasonable assurance necessary to express an opinion on the financial statements, then the auditor's report date is the date that the auditor has obtained sufficient competent evidence to support the representations in the auditor's report. b. Paragraph .05 is replaced with— The independent auditor has two methods for dating the report when a subsequent event disclosed in the financial statements occurs after the auditor has obtained sufficient competent evidence on which to base his or her opinion, but before the issuance of the related financial statements. The auditor may use “dual dating,” for example, “February 16, 20__, except for Note __, as to which the date is March 1, 20__,” or may date the report as of the later date. In the former instance, the responsibility for events occurring subsequent to the original report date is limited to the specific event referred to in the note (or otherwise disclosed). In the latter instance, the independent auditor's responsibility for subsequent events extends to the later report date and, accordingly, the procedures outlined in section 560.12 generally should be extended to that date. c. Within the heading before paragraph .03, the reference to “completion of field work” is replaced with “the date of the independent auditor's report.” AU sec. 543, “Part of Audit Performed by Other Independent Auditors” SAS No. 1, “Codification of Auditing Standards and Procedures,” section 543, “Part of Audit Performed by Other Independent Auditors” (AU sec. 543, “Part of Audit Performed by Other Independent Auditors”), as amended, is amended as follows— Within the note to paragraph .01, the reference to paragraphs 182-185 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs C8-C11 of Appendix C, *Special Reporting Situations* , of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . AU sec. 560, “Subsequent Events” SAS No. 1, “Codification of Auditing Standards and Procedures,” section 560, “Subsequent Events” (AU sec. 560, “Subsequent Events”), as amended, is amended as follows— a. Within the note to paragraph .01, the reference to paragraphs 186-189 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs 93-97 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . b. The second sentence of paragraph .12 is replaced with— These procedures should be performed at or near the date of the auditor's report. AU sec. 561, “Subsequent Discovery of Facts Existing at the Date of the Auditor's Report” SAS No. 1, “Codification of Auditing Standards and Procedures,” section 561, “Subsequent Discovery of Facts Existing at the Date of the Auditor's Report” (AU sec. 561, “Subsequent Discovery of Facts Existing at the Date of the Auditor's Report”), as amended, is amended as follows— Within the note to paragraph .01, the reference to paragraph 197 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraph 98 of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . AU sec. 711, “Filings Under Federal Securities Statutes” SAS No. 37, “Filings Under Federal Securities Statutes” (AU sec. 711, “Filings Under Federal Securities Statutes”), is amended as follows— a. Within the note to paragraph 2, the reference to paragraphs 198-199 of PCAOB Auditing Standard No. 2 is replaced with a reference to paragraphs C16-C17 of Appendix C, *Special Reporting Situations* , of PCAOB Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . b. The third sentence of paragraph 10 is replaced with— The likelihood that the auditor will discover subsequent events necessarily decreases following the date of the auditor's report, and, as a practical matter, after that time the independent auditor may rely, for the most part, on inquiries of responsible officials and employees. AU sec. 722, “Interim Financial Information” SAS No. 100, “Interim Financial Information” (AU sec. 722, “Interim Financial Information”), is amended as follows— a. The following is inserted after the first sentence of paragraph 3— The SEC also requires management, with the participation of the principal executive and financial officers (the certifying officers) to make certain quarterly and annual certifications with respect to the company's internal control over financial reporting. 2 2 *See* Section 302 of the Sarbanes-Oxley Act of 2002, and Securities Exchange Act Rule 13a-14(a) or 15d-14(a), (17 CFR 240.13a-14a or 17 CFR 240.15d-14a), whichever applies. b. The note to paragraph 3 is deleted. c. The following is added to the end of paragraph 7— Likewise, the auditor's responsibility as it relates to management's quarterly certifications on internal control over financial reporting is different from the auditor's responsibility as it relates to management's annual assessment of internal control over financial reporting. The auditor should perform limited procedures quarterly to provide a basis for determining whether he or she has become aware of any material modifications that, in the auditor's judgment, should be made to the disclosures about changes in internal control over financial reporting in order for the certifications to be accurate and to comply with the requirements of Section 302 of the Act. Note: The auditor's responsibilities for evaluating management's certification disclosures about internal control over financial reporting take effect beginning with the first quarter after the company's first annual assessment of internal control over financial reporting as described in Item 308(a)(3) of Regulations S-B and S-K. d. The following lettered section is added to the end of paragraph 18— g. Evaluating management's quarterly certifications about internal control over financial reporting by performing the following procedures— • Inquiring of management about significant changes in the design or operation of internal control over financial reporting as it relates to the preparation of annual as well as interim financial information that could have occurred subsequent to the preceding annual audit or prior review of interim financial information; • Evaluating the implications of misstatements identified by the auditor as part of the auditor's other interim review procedures as they relate to effective internal control over financial reporting; and • Determining, through a combination of observation and inquiry, whether any change in internal control over financial reporting has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting. e. Paragraph 29 is replaced with— As a result of conducting a review of interim financial information, the accountant may become aware of matters that cause him or her to believe that— a. Material modification should be made to the interim financial information for it to conform with generally accepted accounting principles; b. Modification to the disclosures about changes in internal control over financial reporting is necessary for the certifications to be accurate and to comply with the requirements of Section 302 of the Act and Securities Exchange Act Rule 13a-14(a) or 15d-14(a), whichever applies; and c. The entity filed the Form 10-Q or Form 10-QSB before the completion of the review. In such circumstances, the accountant should communicate the matter(s) to the appropriate level of management as soon as practicable. f. Paragraph 32 is replaced with— If the auditor becomes aware of information indicating that fraud or an illegal act has or may have occurred, the auditor must also determine his or her responsibilities under AU sec. 316, *Consideration of Fraud in a Financial Statement Audit* , AU sec. 317, *Illegal Acts by Clients* , and Section 10A of the Securities Exchange Act of 1934. 1 1 *See* 15 U.S.C. 78j-1 g. Within paragraph 33, the third sentence is replaced with— A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting, that is less severe than a material weakness yet important enough to merit attention by those responsible for oversight of the company's financial reporting. Auditing Standard No. 3, Audit Documentation Auditing Standard No. 3, *Audit Documentation* is amended as follows— Within footnote 2 to paragraph 6, the reference to paragraphs 68-70 of Auditing Standard No. 2 is replaced with a reference to paragraphs 28-33 of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements* . Auditing Standard No. 4, Reporting on Whether a Previously Reported Material Weakness Continues to Exist Auditing Standard No. 4, *Reporting on Whether a Previously Reported Material Weakness Continues to Exist* is amended as follows— a. Within note 1 to paragraph 1, the reference to Auditing Standard No. 2 is replaced with a reference to Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* b. Within paragraph 2, the two references to Auditing Standard No. 2 are replaced with references to Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* c. Within the note to paragraph 2, the reference to Auditing Standard No. 2 is replaced with a reference to Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* d. Within paragraph 4, the reference to Auditing Standard No. 2 is replaced with a reference to Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* e. Paragraph 9 is replaced with— The terms *internal control over financial reporting, deficiency, significant deficiency,* and *material weakness* have the same meanings as the definitions of those terms in Appendix A, *Definitions,* of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* f. The first sentence of paragraph 10 is replaced with— Paragraph 5 of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements,* states “[t]he auditor should use the same suitable, recognized control framework to perform his or her audit of internal control over financial reporting as management uses for its annual evaluation of the effectiveness of the company's internal control over financial reporting.” g. Within the note to paragraph 10, the reference to Auditing Standard No. 2 in the first sentence is replaced with a reference to Auditing Standard No. 5, * An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements, * and the last sentence is amended as follows— More information about the COSO framework is included within the COSO report. h. Paragraph 11 is replaced with— The terms *relevant assertion* and *control objective* have the same meaning as the definitions of those terms in Appendix A, *Definitions,* of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* i. Paragraph 13 is replaced with— In an audit of internal control over financial reporting, the auditor should test the design effectiveness of controls by determining whether the company's controls, if they are operated as prescribed by persons possessing the necessary authority and competence to perform the control effectively, satisfy the company's control objectives and can effectively prevent or detect errors or fraud that could result in material misstatements in the financial statements. 2 2 *See* paragraph 42 of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* j. Within the note to paragraph 17, the reference to Auditing Standard No. 2 is replaced with a reference to Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* k. Within note 2 to paragraph 18, the reference to Auditing Standard No. 2 is replaced with a reference to Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* l. Within paragraph 21, the last sentence is deleted. m. Within paragraph 23, the reference to paragraphs 22 and 23 of Auditing Standard No. 2 is replaced with a reference to paragraph 20 of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* Additionally, the second sentence is deleted. n. Within paragraph 24, the reference to paragraph 39 of Auditing Standard No. 2 is replaced with a reference to paragraph 9 of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* o. Within paragraph 25, the reference to Auditing Standard No. 2 is replaced with a reference to Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* p. Within the note to paragraph 25, the two references to Auditing Standard No. 2 are replaced with references to Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* q. Within subparagraph a. of paragraph 26, the reference to paragraphs 47 through 51 of Auditing Standard No. 2 is replaced with a reference to paragraphs 22-27 of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* r. Subparagraph b. of paragraph 26 is replaced with— Perform the procedures described in paragraphs 34-38 of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements,* for those transactions that are directly affected by controls specifically identified by management as addressing the material weakness. s. The note to subparagraph b. of paragraph 26 is deleted. t. Within paragraph 27, the reference to Auditing Standard No. 2 is replaced with a reference to Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* u. The note to paragraph 28 is deleted. v. Within paragraph 31, the reference to paragraphs 88 through 91 of Auditing Standard No. 2 is replaced with a reference to paragraphs 42-43 of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* w. Paragraph 32 is replaced with— Consistent with the direction in paragraphs 44-45 of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements,* the auditor should test the operating effectiveness of a specified control by determining whether the specified control operated as designed and whether the person performing the control possesses the necessary authority and qualifications to perform the control effectively. In determining the nature, timing, and extent of tests of controls, the auditor should apply paragraphs 50-54 of Auditing Standard No. 5. x. Paragraph 33 is replaced with— The auditor should perform tests of the specified controls over a period of time that is adequate to determine whether, as of the date specified in management's assertion, the controls necessary for achieving the stated control objective are operating effectively. The timing of the auditor's tests should vary with the risk associated with the control being tested. For example, a transaction-based, daily reconciliation generally would permit the auditor to obtain sufficient evidence as to its operating effectiveness in a shorter period of time than a pervasive, entity-level control, such as any of those described in paragraphs 22-24 of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* Additionally, the auditor typically will be able to obtain sufficient evidence as to the operating effectiveness of controls over the company's period-end financial reporting process only by testing those controls in connection with a period-end. y. Within paragraph 35, the reference to paragraphs B1 through B13 of Appendix B of Auditing Standard No. 2 is replaced with a reference to paragraphs B10-B16 of Appendix B, *Special Topics,* of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* z. Within paragraph 36, the reference to paragraphs 109 through 115 and 117 through 125 of Auditing Standard No. 2 is replaced with a reference to paragraphs 16-19 of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* aa. The second sentence of paragraph 37 is replaced with— Therefore, if the auditor has been engaged to report on more than one material weakness or on more than one stated control objective, the auditor must evaluate whether he or she has obtained sufficient evidence that the control objectives related to each of the material weaknesses identified in management's assertion are achieved. bb. The first two sentences of paragraph 38 are replaced with— Paragraphs 18-19 of Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements,* should be applied in the context of the engagement to report on whether a previously reported material weakness continues to exist. cc. The note to paragraph 38 is deleted. dd. The note to paragraph 39 is deleted. ee. Paragraph 42 is replaced with— Management may conclude that a previously reported material weakness no longer exists because its severity has been sufficiently reduced such that it is no longer a material weakness. ff. Subparagraph f. of paragraph 44 is replaced with— Describing any fraud resulting in a material misstatement to the company's financial statements and any other fraud that does not result in a misstatement in the company's financial statements but involves senior management or management or other employees who have a significant role in the company's internal control over financial reporting and that has occurred or come to management's attention since the date of management's most recent annual assessment of internal control over financial reporting. gg. Within the note to subparagraph b. of paragraph 51, the reference to Auditing Standard No. 2 is replaced with a reference to Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* hh. Within the note to subparagraph l. of paragraph 51, the reference to Auditing Standard No. 2 is replaced with a reference to Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* ii. Within the note to the second bullet point of subparagraph o. of paragraph 51, the reference to Auditing Standard No. 2 is replaced with a reference to Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* jj. Within paragraph 52, the reference to Auditing Standard No. 2 is replaced with a reference to Auditing Standard No. 5, *An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.* kk. Within paragraph 63, the reference to paragraphs 202 through 206 of Auditing Standard No. 2 is replaced with a reference to paragraphs 7 and 29-32 of AU sec. 722, *Interim Financial Information.* ll. Within paragraph 64, the reference to paragraphs 202 through 206 of Auditing Standard No. 2 is replaced with a reference to paragraphs 7 and 29-32 of AU sec. 722, *Interim Financial Information.* II. Board's Statement of the Purpose of, and Statutory Basis for, the Proposed Rules In its filing with the Commission, the Board included statements concerning the purpose of, and basis for, the proposed rule and discussed any comments it received on the proposed rule. The text of these statements may be examined at the places specified in Item IV below. The Board has prepared summaries, set forth in sections A, B, and C below, of the most significant aspects of such statements. A. Board's Statement of the Purpose of, and Statutory Basis for, the Proposed Rules
(a)Purpose In 2002, Congress passed the Act, which, among other things, established new provisions related to internal control over financial reporting. Section 404 of the Act requires company management to assess and report on the effectiveness of the company's internal control. It also requires a company's independent auditor, registered with the Board, to attest to management's disclosures regarding the effectiveness of its internal control. As directed by Sections 103 and 404 of the Act, the Board established a standard to govern the newly required audit by adopting Auditing Standard No. 2, *An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements* (“Auditing Standard No. 2”). The SEC approved Auditing Standard No. 2 on June 17, 2004. Since Auditing Standard No. 2 became effective, the Board has closely monitored the progress registered firms have made in implementing its requirements. The PCAOB's monitoring has included gathering information during inspections of registered public accounting firms; participating, along with the SEC, in two roundtable discussions with representatives of issuers, auditors, investor groups, and others; meeting with its Standing Advisory Group; receiving feedback from participants in the Board's Forums on Auditing in the Small Business Environment; and reviewing academic, government, and other reports and studies. As a result of this monitoring, two basic propositions emerged. First, the audit of internal control over financial reporting has produced significant benefits, including an enhanced focus on corporate governance and controls and higher quality financial reporting. Second, these benefits have come at a significant cost. Costs have been greater than expected and, at times, the related effort has appeared greater than necessary to conduct an effective audit of internal control over financial reporting. As part of a four-point plan to improve implementation of the internal control requirements, the Board determined to amend Auditing Standard No. 2. On December 19, 2006, the Board proposed for comment a new standard on auditing internal control, *An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements,* that would replace Auditing Standard No. 2. After careful consideration of the comments it received and the input from the SEC, the Board has refined its proposals to provide additional clarity and further help auditors to focus on the most important matters. The Board adopted the revised standard on auditing internal control as Auditing Standard No. 5, to supersede Auditing Standard No. 2. Under Section 10A(i) of the Exchange Act, as amended by Section 202 of the Act, all non-audit services that the auditor proposes to perform for an issuer client “shall be pre-approved by the audit committee of the issuer.” Rule 3525 would further implement the Act's pre-approval requirement by requiring auditors to take certain steps as part of seeking audit committee pre-approval of internal control related non-audit services. These steps are intended to ensure that audit committees are provided relevant information for them to make an informed decision on how the performance of internal control-related services may affect independence. Rule 3525 requires a registered public accounting firm that seeks pre-approval of an issuer audit client's audit committee to perform internal control-related non-audit services that are not otherwise prohibited by the Act or the rules of the SEC or the Board to: Describe, in writing, to the audit committee the scope of the proposed service; discuss with the audit committee the potential effects of the proposed service on the firm's independence; and document the substance of the firm's discussion with the audit committee. The conforming amendments update the Board's other auditing standards in light of Auditing Standard No. 5, move information contained in Auditing Standard No. 2 to the Board's interim standards, and change the existing requirement that “generally, the date of completion of the field work should be used as the date of the independent auditor's report” to “the auditor should date the audit report no earlier than the date on which the auditor has obtained sufficient competent evidence to support the auditor's opinion.” This change is consistent with a recent change adopted by both the International Auditing and Assurance Standards Board and the AICPA Auditing Standards Board.
(b)Statutory Basis The statutory basis for the proposed rule is Title I and II and Section 404 of the Act. B. Board's Statement on Burden on Competition The Board does not believe that the proposed rule will result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act. The proposed rules would apply equally to all registered public accounting firms and their associated persons. Moreover, Auditing Standard No. 5 explains how to tailor internal control audits to fit the size and complexity of the company being audited. C. Board's Statement on Comments on the Proposed Rule Received From Members, Participants or Others The Board released the proposed rules for public comment in Release No. 2006-007 (December 19, 2006). A copy of Release No. 2006-007 and the comment letters received in response to the PCAOB's request for comment are available on the PCAOB's Web site at *http://www.pcaobus.org.* The Board received 175 written comments. The Board also discussed the proposals with its Standing Advisory Group on February 22, 2007. 1 The Board has clarified and modified certain aspects of the proposed rules in response to the comments it received, as discussed below. 1 A transcript of the portion of the meeting that related to the proposals and an archived web cast of the entire meeting are available on the Board's Web site at *http://www.pcaobus.org/Standards/Standing_Advisory_Group/Meetings/2007/02-22/SAG_Transcript.pdf* . The Board issued these proposals with the primary objectives of focusing auditors on the most important matters in the audit of internal control over financial reporting and eliminating procedures that the Board believes are unnecessary to an effective audit of internal control. The proposals were designed to both increase the likelihood that material weaknesses in companies' internal control will be found before they cause material misstatement of the financial statements and steer the auditor away from procedures that are not necessary to achieve the intended benefits. The Board also sought to make the internal control audit more clearly scalable for smaller and less complex public companies and to make the text of the standard easier to understand. In formulating these proposals, the Board re-evaluated every significant aspect of Auditing Standard No. 2. A large majority of commenters were generally supportive of the Board's proposals, particularly the top-down, risk-based approach and focus on the most important matters. Based on the comments received, the Board believes that the proposal achieves, in large part, the objectives the Board set out when deciding to amend Auditing Standard No. 2. Many commenters also offered suggestions to improve the final standard, which the Board has carefully analyzed. In considering the comments received and formulating a final standard, the Board closely coordinated its work with the SEC, which proposed guidance for management on evaluating internal control at the same time that the Board issued its proposals. 2 In addition to its role in implementing Section 404(a) of the Act, the SEC must approve new PCAOB auditing standards before they can become effective. 3 On April 4, 2007, the Commission held a public meeting to discuss the Board's proposals and the coordination of those proposals with the Commission's proposed management guidance. At the meeting, the SEC staff provided the Commission its analysis of the public comments on the PCAOB's proposal and the proposed management guidance. The Commission endorsed the recommendations of its staff and directed its staff to focus its remaining work in four areas: 2 *See* Securities Exchange Act Release No. 54976 (Dec. 20, 2006). 3 *See* Section 107 of the Act. • “Aligning the PCAOB's new auditing standard * * * with the SEC's proposed new management guidance under Section 404, particularly with regard to prescriptive requirements, definitions, and terms”; • “Scaling the 404 audit to account for the particular facts and circumstances of companies, particularly smaller companies”; • “Encouraging auditors to use professional judgment in the 404 process, particularly in using risk-assessment”; and • “Following a principles-based approach to determining when and to what extent the auditor can use the work of others.” 4 4 *See* SEC Press Release, “SEC Commissioners Endorse Improved Sarbanes-Oxley Implementation To Ease Smaller Company Burdens, Focusing Effort On ‘What Truly Matters’ ” (Apr. 4, 2007). After careful consideration of the comments it received and the input from the SEC, the Board has refined its proposals to provide additional clarity and further help auditors to focus on the most important matters. The Board has decided to adopt the revised standard on auditing internal control as Auditing Standard No. 5, to supersede Auditing Standard No. 2. The Board has also decided to adopt the independence rule and conforming amendments to the auditing standards. 5 5 As discussed below, the Board has determined not to adopt the proposed auditing standard on considering and using the work of others. Notable Areas of Change in the Final Standard The Board believes that the changes made to the proposal reflect refinements, rather than significant shifts in approach. This section describes the areas of change to the proposals that are most notable. Additional discussion of comments received on the proposals and the Board's response is included below. Alignment With Management Guidance On December 20, 2006, the SEC issued proposed guidance to help management evaluate internal control for purposes of its annual assessment. In formulating a new standard on auditing internal control, the Board sought to describe an audit process that would be coordinated with management's evaluation process. Many commenters suggested, however, that the SEC's management guidance and the Board's standard should be more closely aligned. After considering the comments in this area, the Board has decided to make changes that will improve the coordination between the SEC's management guidance and the Board's standard. In doing so, the Board has been mindful of the inherent differences in the roles of management and the auditor. Management's daily involvement with its internal control system provides it with knowledge and information that may influence its judgments about how best to evaluate internal control and the sufficiency of the evidence it needs for its annual assessment. Management also should be able to rely on self-assessment and, more generally, the monitoring component of internal control, provided the monitoring component is properly designed and operates effectively. The auditor is required to provide an independent opinion on the effectiveness of the company's internal control over financial reporting. The auditor does not have the familiarity with the company's controls that management has and does not interact with or observe these controls with the same frequency as management. Therefore, the auditor cannot obtain sufficient evidence to support an opinion on the effectiveness of internal control based solely on observation of or interaction with the company's controls. Rather, the auditor needs to perform procedures such as inquiry, observation, and inspection of documents, or walkthroughs, which consist of a combination of those procedures, in order to fully understand and identify the likely sources of potential misstatements, while management might be aware of those risk areas on an on-going basis. The Board believes, however, that the general concepts necessary to an understanding of internal control should be described in the same way in the Board's standard and in the SEC's guidance. Accordingly, the Board has decided to use the same definition of material weakness in its standard that the SEC uses in its final management guidance and related rules. In addition, the Board is adopting the definition of significant deficiencies that the SEC has proposed. The final standard and final management guidance also describe the same indicators of a material weakness. In addition, as described more fully below, the final standard on auditing internal control uses the term “entity-level controls” instead of “company-level controls,” which was used in the proposed standard, in order to use the same term as the SEC uses in its final management guidance. 6 Auditing Standard No. 5's discussion of the effect of these controls is also consistent with the discussion of the same topic in the SEC's final guidance. 6 These terms were used interchangeably in the proposed standard and SEC's proposed management guidance and, for these purposes, they mean the same thing. *See* Securities Exchange Act Release No. 54976 (Dec. 20, 2006), at 12 fn. 29. The Top-Down Approach The proposed standard on auditing internal control was structured around the top-down approach to identifying the most important controls to test. This approach follows the same principles that apply to the financial statement audit—the auditor determines the areas of focus through the identification of significant accounts and disclosures and relevant assertions. Under the proposed standard, the auditor would specifically identify major classes of transactions and significant processes before identifying the controls to test. In response to comments about the level of detail in the requirements of the proposed standard, the Board has reconsidered whether the final standard should include the identification of major classes of transactions and significant processes as a specifically required step in the top-down approach. As a practical matter, the auditor will generally need to understand the company's processes to appropriately identify the correct controls to test. The Board believes, however, that specific requirements directing the auditor how to obtain that understanding are unnecessary and could contribute to a “checklist approach” to compliance, particularly for auditors who have a longstanding familiarity with the company. Accordingly, the Board has removed the requirements to identify major classes of transactions and significant processes from the final standard. While this should allow auditors to apply more professional judgment as they work through the top-down approach, the end point is the same as in the proposed standard—the requirement to test those controls that address the assessed risk of misstatement to each relevant assertion. 7 7 *See* paragraph 21. Emphasis on Fraud Controls The proposed standard on auditing internal control discussed fraud controls and the auditor's procedures related to these controls among the testing concepts included near the end of the standard. Commenters suggested that the placement of the discussion, or the lack of specificity regarding the controls that should be deemed fraud controls, failed to properly emphasize these controls or provide auditors with sufficient direction on how to test fraud controls. In response, the Board has made several changes in the final standard. First, the discussion of fraud risk and anti-fraud controls has been moved closer to the beginning of the standard to emphasize to auditors the relative importance of these matters in assessing risk throughout the top-down approach. 8 Incorporating the auditor's fraud risk assessment—required in the financial statement audit—into the auditor's planning process for the audit of internal control should promote audit quality as well as better integration. While internal control cannot provide absolute assurance that fraud will be prevented or detected, these controls should help to reduce instances of fraud, and, therefore, a concerted focus on fraud controls in the internal control audit should enhance investor protection. Second, management fraud has also been identified in the final standard as an area of higher risk; accordingly, the auditor should focus more of his or her attention on this area. 9 Finally, the standard, as adopted, provides additional guidance on the types of controls that might address fraud risk. 10 8 *See* paragraphs 14 and 15. 9 *See* paragraph 11. 10 *See* paragraph 14. Entity-Level Controls The proposed standard on auditing internal control emphasized entity-level controls because of their importance both to the auditor's ability to appropriately tailor the audit through a top-down approach— specifically by identifying and testing the most important controls—and to effective internal control. Additionally, the proposed standard emphasized that these controls might, depending on the circumstances, allow the auditor to reduce the testing of controls at the process level. Commenters suggested that the proposed standard did not provide enough direction on how entity-level controls can significantly reduce testing, and some suggested that controls that operate at the level of precision necessary to do so are uncommon. Many commenters suggested incorporating in the final standard the discussion of direct versus indirect entity-level controls that was included in the SEC's proposed management guidance. The Board continues to believe that entity-level controls, depending on how they are designed and operate, can reduce the testing of other controls related to a relevant assertion. This is either because the entity-level control sufficiently addresses the risk related to the relevant assertion, or because the entity-level controls provide some assurance so that the testing of other controls related to that assertion can be reduced. In response to comments and in order to clarify these concepts, the Board included in the final standard a discussion of three broad categories of entity-level controls, which vary in nature and precision, along with an explanation of how each category might have a different effect on the performance of tests of other controls. 11 11 *See* paragraph 23. The Board believes that expertise of auditors and companies in the area of entity-level controls will continue to evolve. For example, the Committee of Sponsoring Organizations of the Treadway Commission has begun a project on the monitoring component of internal control that may provide some guidance in this area. The final standard explains that some controls, such as certain control environment controls, have an important, but indirect effect, on the likelihood that a misstatement will be detected or prevented on a timely basis. These controls might affect the other controls the auditor selects for testing and the nature, timing, and extent of procedures the auditor performs on other controls. The final standard explains that other entity-level controls may not operate at the level of precision necessary to eliminate the need for testing of other controls, but can reduce the required level of testing of other controls, sometimes substantially. This is because the auditor obtains some of the supporting evidence related to a control from an entity-level control and the remaining necessary evidence from the testing of the control at the process level. Controls that monitor the operation of other controls are the best example of these types of controls. These monitoring controls help provide assurance that the controls that address a particular risk are effective and, therefore, they can provide some evidence about the effectiveness of those lower-level controls, reducing the testing of those controls that otherwise would be necessary. Lastly, the final standard explains that some entity-level controls might operate at a level of precision that, without the need for other controls, sufficiently addresses the risk of misstatement to a relevant assertion. If a control sufficiently addresses the risk in this manner, the auditor does not need to test other controls related to that risk. Walkthroughs The proposed standard on auditing internal control would have required auditors to perform a walkthrough of each significant process each year. This proposed requirement represented a change from Auditing Standard No. 2, which required a walkthrough of each major class of transactions within a significant process. Commenters were split on the question of whether the re-calibration from major class of transactions to significant process in the proposed standard would result in a reduction of effort. Some issuers and auditors suggested that walkthroughs are already being performed on significant processes, while other issuers and auditors commented that this proposed requirement would make a difference. A few commenters suggested that a walkthrough of each significant process was insufficient and would negatively affect audit quality, but many others stated that walkthroughs should not be required at all. In evaluating these comments, the Board focused principally on the objectives it believes are achieved through a properly performed walkthrough. The Board firmly believes that those objectives should be met for the auditor to verify that he or she has a sufficient understanding of the points within the processes where misstatements could occur and to properly identify the controls to test. 12 Procedures that fulfill those objectives also play an important role in the evaluation of the effectiveness of the design of the controls. The Board believes that, in some instances, the requirement to perform a walkthrough may have overshadowed the objectives it was meant to achieve. This may have resulted in some walkthroughs being performed to meet the requirement but failing to achieve the intended purpose. 12 *See* paragraph 34, which describes these objectives. The final standard, therefore, focuses specifically on achieving certain important objectives, and the performance requirement is based on fulfilling those objectives as they relate to the understanding of likely sources of misstatement and the selection of controls to test. 13 While a walkthrough will frequently be the best way of attaining these goals, the auditor's focus should be on the objectives, not on the mechanics of the walkthrough. In some cases, other procedures may be equally or more effective means of achieving them. 13 *See* paragraph 34. Evaluation and Communication of Deficiencies The proposed standard on auditing internal control required the auditor to evaluate the severity of identified control deficiencies to determine whether they are significant deficiencies or material weaknesses. It then required the auditor to communicate, in writing, to management and the audit committee all significant deficiencies and material weaknesses identified during the audit. The proposed standard defined “significant deficiency” as “a control deficiency, or combination of control deficiencies, such that there is a reasonable possibility that a significant misstatement of the company's annual or interim financial statements will not be prevented or detected.” The term “significant misstatement” was defined, in turn, to mean “a misstatement that is less than material yet important enough to merit attention by those responsible for oversight of the company's financial reporting.” Commenters generally supported the proposed definition of the term “significant misstatement,” though some were concerned that it was too subjective. Other commenters questioned whether the standard should include a definition of significant deficiency and a requirement to communicate significant deficiencies to the audit committee. At least one commenter suggested that the term be removed from the standard. After considering these comments, the Board has determined to make changes to the definition of significant deficiency and related requirements. 14 The Board continues to believe that the standard should require auditors to provide relevant information about important control deficiencies—even those less severe than a material weakness—to management and to the audit committee. The final standard, therefore, requires the auditor to consider and communicate any identified significant deficiencies to the audit committee. In order to emphasize that the auditor need not scope the audit to identify all significant deficiencies, however, the Board placed these provisions in the section of the final standard that describes communications requirements. 15 14 The Board also made minor changes to the definition of material weakness in order to use the same definition in the SEC's management guidance and related rule. In the final standard, material weakness is defined as “a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis.” 15 *See* paragraph 80. The final standard also includes the proposed requirement for the auditor to communicate, in writing, to management, all deficiencies in internal control identified during the audit and inform the audit committee when such a communication has been made, and the proposed requirement to inform, when applicable, the board of directors of the auditor's conclusion that the audit committee's oversight is ineffective. *See* paragraphs 79 and 81. Some commenters believed that the requirement to communicate all identified deficiencies to management would result in an unnecessary administrative exercise. The Board continues to believe, however, that auditors should provide information about identified control deficiencies to management. The relatively minor changes that the Board made to the definition of significant deficiency are also intended to focus the auditor on the communication requirement and away from scoping issues. The final definition is based on the proposed definition of “significant misstatement,” which commenters generally supported, and is aligned with the SEC's proposed definition of the same term. Under the final standard, a significant deficiency is “a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness yet important enough to merit attention by those responsible for oversight of the company's financial reporting.” Scaling the Audit The proposed standard on auditing internal control indicated that a company's size and complexity are important considerations and that the procedures an auditor should perform depend upon where along the size and complexity continuum a company falls. The proposed standard included a section on scaling the audit for smaller, less complex companies and would have required auditors to evaluate and document the effect of the company's size and complexity on the audit. This documentation requirement applied to audits of companies of all sizes. The proposed standard also included a list of the attributes of smaller, less complex companies and a description of how the auditor might tailor his or her procedures when these attributes are present. In general, commenters were supportive of the proposed standard's general approach to scalability, but had several recommendations for change. Some commenters suggested that scalability should not be covered as a stand-alone discussion applicable only to smaller companies and that other companies, regardless of size, might have areas that are less complex. The Board agrees that the direction on scaling will be most effective if it is a natural extension of the risk-based approach and applicable to all companies. Consequently, the Board shortened the separate section on “scaling the audit,” and incorporated a discussion of scaling concepts, similar to what was proposed, throughout the final standard. Specifically, notes to relevant paragraphs describe how to tailor the audit to the particular circumstances of a smaller, less complex company or unit. The Board also retained the list of attributes of smaller, less complex companies and acknowledged that, even within larger companies, some business units or processes may be less complex than others. Discussion of these attributes has been incorporated in the section on the auditor's planning procedures in the final standard. 16 As described in the proposing release, the provisions on scalability in the final standard will form the basis for guidance on auditing internal control in smaller companies to be issued this year. 16 *See* paragraph 9. Several commenters, mostly auditors, suggested that the performance requirements that applied to all companies, including large, complex companies, would lead to unnecessary and costly documentation requirements. These commenters were particularly concerned about the requirement to document the effects of size and complexity on all aspects of the audit, even if a particular engagement could not be tailored as a result of these factors. After considering these comments, the Board agreed that this documentation requirement is not necessary to promote audit quality and, therefore, has not included it in the final standard. Use of the Work of Others in an Integrated Audit At the time the Board proposed Auditing Standard No. 5 for public comment, the Board also proposed an auditing standard entitled *Considering and Using the Work of Others in an Audit* that would have superseded the Board's interim standard AU sec. 322, *The Auditor's Consideration of the Internal Audit Function in an Audit of Financial Statements* (“AU sec. 322”), and replaced the direction on using the work of others in an audit of internal control in Auditing Standard No. 2. As discussed in the proposing release, the Board had several objectives in proposing this standard. The first was to better integrate the financial statement audit and the audit of internal control by having only one framework for using the work of others in both audits. Additionally, the Board wanted to encourage auditors to use the work of others to a greater extent when the work is performed by sufficiently competent and objective persons. Among other things, under the proposed standard, auditors would have been able to use the work of sufficiently competent and objective company personnel—not just internal auditors—and third parties working under the direction of management or the audit committee for purposes of the financial statement audit as well as the audit of internal control. The Board received numerous comments on the proposed standard on using the work of others. Commenters generally indicated support for a single framework regarding the auditor's use of the work of others in an integrated audit. Some, however, suggested retaining existing AU sec. 322 as the basis for that single framework. They expressed the view that the objective of removing barriers to integration and using the work of others to the fullest extent appropriate could be achieved by retaining AU sec. 322 and going forward with the proposed removal of the “principal evidence” provision. At the same time, some other commenters suggested that the proposed standard did not go far enough in encouraging auditors to use the work of others. After considering these comments, the Board continues to believe that a single framework for the auditor's use of the work of others is preferable to separate frameworks for the audit of internal control and the audit of financial statements. The factors used to determine whether and to what extent it is appropriate to use the work of others should be the same for both audits. At the same time, the Board agreed with those commenters who suggested that better integration of the audits could be achieved without replacing the existing auditing standard. The Board therefore has decided to retain AU sec. 322 for both audits and incorporate language into Auditing Standard No. 5 that establishes these integration concepts rather than adopt the proposed standard on considering and using the work of others. Consistent with the proposal, however, Auditing Standard No. 5 allows the auditor to use the work of others to obtain evidence about the design and operating effectiveness of controls and eliminates the principal evidence provision. Recognizing that issuers might employ personnel other than internal auditors to perform activities relevant to management's assessment of internal control over financial reporting, the final standard allows the auditor to use the work of company personnel other than internal auditors, as well as third parties working under the direction of management or the audit committee. 17 17 *See* paragraph 17. In line with the overall risk-based approach to the audit of internal control over financial reporting, the extent to which the auditor may use the work of others depends, in part, on the risk associated with the control being tested. As the risk decreases, so does the need for the auditor to perform the work him or herself. The impact of the work of others on the auditor's work also depends on the relationship between the risk and the competence and objectivity of those who performed the work. As the risk decreases, the necessary level of competence and objectivity decreases as well. 18 Likewise, in higher risk areas (for example, controls that address specific fraud risks), use of the work of others would be limited, if it could be used at all. 18 *See* paragraph 18. Finally, the Board understands that some of the work performed by others for the purposes of management's assessment of internal controls can be relevant to the audit of financial statements. Therefore, in an integrated audit, the final standard allows the auditor to use the work of these sufficiently competent and objective others—not just internal auditors—to obtain evidence supporting the auditor's assessment of control risk for purposes of the audit of financial statements. 19 The Board believes that this provision will promote better integration of the audit of internal control with the audit of financial statements. 19 *See* paragraph 17. Rule 3525—Audit Committee Pre-Approval of Non-Audit Services Related to Internal Control Over Financial Reporting The Board also proposed a new rule related to the auditor's responsibilities when seeking audit committee pre-approval of internal control related non-audit services. As proposed, the rule required a registered public accounting firm that seeks pre-approval of an issuer audit client's audit committee to perform internal control-related non-audit services that are not otherwise prohibited by the Act or the rules of the SEC or the Board to: describe, in writing, to the audit committee the scope of the proposed service; discuss with the audit committee the potential effects of the proposed service on the firm's independence; and document the substance of the firm's discussion with the audit committee. These requirements parallel the auditor's responsibility in seeking audit committee pre-approval to perform tax services for an audit client under PCAOB Rule 3524. Most commenters were supportive of the rule as proposed, though some offered suggestions about what should be included in the required communication. After considering the comments on the proposed rule, the Board has adopted it without change. Conforming Amendments As part of the proposal issued for public comment, the Board proposed amendments to certain of the Board's other auditing standards. Only one comment letter specifically addressed the proposed amendments. That letter expressed support for the amendments and suggested a few additional amendments that might be necessary. The Board has considered this comment and added these additional amendments, as well as others, as necessary based on the final standard. Effective Date The proposing release solicited commenters' feedback on how the Board could structure the effective date of the final requirements so as to best minimize disruption to ongoing audits, but make greater flexibility available to auditors as early as possible. Most commenters on this topic suggested making the final standard on auditing internal control effective as soon as possible in order to be available for 2007 audits. The Board agrees that the improvements in Auditing Standard No. 5 should be available as soon as possible. Accordingly, the Board has determined that Auditing Standard No. 5, Rule 3525, and the conforming amendments will be effective, subject to approval by the SEC, for audits of fiscal years ending on or after November 15, 2007. Earlier adoption is permitted, however, at any point after SEC approval. Auditors who elect to comply with Auditing Standard No. 5 after SEC approval but before its effective date must also comply, at the same time, with Rule 3525 and other PCAOB standards as amended by this release. Auditing Standard No. 2 will be superseded when Auditing Standard No. 5 becomes effective. Auditors who do not elect to comply with Auditing Standard No. 5 before that date (but after SEC approval) must continue to comply with Auditing Standard No. 2 until it is superseded. Such auditors should, however, apply the definition of “material weakness” contained in Auditing Standard No. 5, rather than the one contained in Auditing Standard No. 2. The SEC has adopted a rule to define the term “material weakness,” and the definition in Auditing Standard No. 5 parallels the new SEC definition. Additional Discussion of Comments and the Board's Response Alignment of Board's Internal Control Auditing Standard and the SEC's Guidance to Management Many commenters suggested that the SEC's guidance to management and the Board's auditing standard should be more closely aligned. The commenters appeared to hold different opinions, however, about what alignment should mean in this context. Some commenters suggested that the most important issue was the need to use the same definitions of important terms in both documents. Some focused on perceived differences in scope, testing, and documentation requirements, while others suggested that the tone of the two documents was different and that the Board's proposals were more prescriptive. A few commenters suggested that the standard on auditing internal control should merely refer to the SEC management guidance without providing additional direction to the auditor. As discussed above, in formulating a new standard on auditing internal control, the Board intended to describe an audit process that would be coordinated with management's evaluation process. After considering the comments in this area, the Board made several changes, described above, that improve coordination while recognizing the inherent differences in the roles of management and the independent auditor under Section 404. The Board also adopted, as proposed, the final standard without a requirement for the auditor to perform an evaluation of management's assessment process. Commenters generally supported this aspect of the proposal, which was intended to respond to concerns that the requirements of Auditing Standard No. 2 had become de facto guidance for management's process. The absence of this requirement in the final standard should also allow for improved coordination between management and the auditor. Level of Prescriptive Detail Some commenters suggested that there remained too many instances of the use of the terms “should” and “must” in the proposed standard and that this might drive excessive documentation and possibly unnecessary work. The Board's Rule 3101 describes the level of responsibility that these imperatives impose on auditors when used in PCAOB standards, and the Board uses these terms in its standards to clearly convey its expectations. In response to these comments, the Board analyzed each requirement in the proposed standard to determine whether more reliance could be placed on general principles rather than detailed requirements. Where appropriate, the Board made modifications to make the final standard more principles-based. As discussed more fully above, areas in which changes were made include the focus on fulfilling the objectives of a walkthrough and in the description of the top-down approach. Some of these changes also contributed to better coordination with the SEC's guidance for management. In addition, several commenters expressed concern over the creation of presumptively mandatory responsibilities related to efficiency concepts. The example cited most often was the note to paragraph 3 of the proposed standard on auditing internal control, which stated— Note: The auditor should select for testing only those controls that are important to the auditor's conclusion about whether the company's controls sufficiently address the assessed risk of misstatement to a given relevant assertion that could result in a material misstatement to the company's financial statements. Commenters suggested that because of this requirement for the auditor to select “only those controls that are important” for testing, an auditor would have violated the Board's standards if he or she tested even one control that was later shown to be not important. Commenters believed that this would undermine audit effectiveness and recommended removal of such statements. One of the objectives of the revised standard is to encourage auditors to focus on those areas that present the greatest risk of allowing a material misstatement in the financial statements. However, the Board agrees that its standards should not define a ceiling or maximum amount of work which the auditor may not exceed. While this statement (and others like it) in the proposed standard was not intended to imply that the Board would, with hindsight, suggest that an auditor violated the standard through testing of a control that was later determined to be not important to the audit, the Board has removed the note to paragraph 3 in response to these comments. Similar statements throughout the standard have also either been removed or modified. Walkthroughs The proposed standard required that the auditor perform a walkthrough of each significant process each year and allowed the auditor to use others, such as management personnel and internal auditors, to directly assist the auditor in this work. The proposed standard also indicated that the walkthrough provides audit evidence but did not prescribe further requirements regarding the circumstances in which a walkthrough might provide the auditor with sufficient evidence of operating effectiveness for a particular control. The proposing release, however, noted that a walkthrough could be sufficient for some low-risk controls in subsequent years. As discussed above, the Board received a significant number of comments on this topic. While several commenters expressed support for the importance of the walkthrough to audit quality, many commenters suggested that the proposed provisions in this area were more prescriptive than necessary, and suggested risk concepts as a way to add flexibility. While these commenters acknowledged the value of a walkthrough and its importance to the evaluation of design effectiveness, many stated that the requirement to perform a walkthrough in an area that is either low-risk, not complex, or unchanged appears inconsistent with the other areas in the proposed standard that rely upon auditor judgment to a much greater extent. Use of Others in Achieving the Objectives of a Walkthrough Commenters supported allowing the auditor to use others to provide the auditor with direct assistance, particularly in low-risk areas, with only a few commenters believing that this change could jeopardize the quality of the audit. In addition, many commenters believed that the standard should allow full use of the work of others in performing walkthroughs, although some commenters strongly disagreed with this point. As discussed above, the final standard focuses the auditor on achieving four objectives related to the identification of where within the company's processes misstatements could arise, rather than specifically on performing walkthroughs. Due to the importance of achieving these objectives to the auditor's conclusion about internal control, the Board believes that allowing the use of the work of others to a greater extent than what was proposed would not provide the auditor with an adequate understanding of the relevant risks and the related controls. Therefore, similar to the proposed standard, Auditing Standard No. 5 allows the auditor to use the work of others in achieving the objectives of a walkthrough, but only as direct assistance. That is, the auditor will be required to supervise, review, evaluate, and test the work performed by others. 20 20 *See* paragraph 27 of AU sec. 322, *The Auditor's Consideration of the Internal Audit Function in an Audit of Financial Statements* . Using Walkthroughs To Test Operating Effectiveness On the subject of using walkthroughs to test operating effectiveness, commenters suggested that walkthroughs can provide sufficient evidence of operating effectiveness, but held different views about situations in which this would be the case. Some commenters supported the use of walkthroughs in low-risk areas, while others focused on whether the control itself should be low-risk. Several commenters suggested that a walkthrough could provide sufficient evidence of operating effectiveness for lower-risk controls but only when entity-level controls are strong. Almost all commenters agreed that the proposed standard focused on the appropriate conditions for using such an approach—specifically, when risk is low, when past audits indicate effective design and operation of the control, and when no changes have been made to the control or process in which the control resides. After considering these comments, the Board has decided that the risk-based approach that is described in the final standard is the appropriate framework for determining the evidence necessary to support the auditor's opinion. Therefore, Auditing Standard No. 5 articulates the principle that performance of a walkthrough might provide sufficient evidence of operating effectiveness, depending on the risk associated with the control being tested, the specific procedures performed as part of the walkthroughs and the results of the procedures performed. 21 The Board believes that establishing more detailed requirements in this area is not necessary, because application of the general principle in the standard will depend on the particular facts and circumstances presented. 21 *See* paragraph 49. Assessing Risk The Board's May 16, 2005 guidance emphasized the importance of risk assessment in the audit of internal control, and that element of the guidance was incorporated and enhanced in the proposed standard. The proposed standard required risk assessment at each of the decision points in a top-down approach, including the auditor's identification of significant accounts and disclosures and their relevant assertions. The proposed standard also required an assessment of risk at the individual control level, and required that the auditor determine the evidence necessary for a given control based on this risk assessment. The Board received many comments on the risk assessment provisions in the proposed standard. Comments on the proposed risk assessment approach were generally supportive, with some commenters suggesting ways for improving the risk assessment emphasis in the standard. Many commenters discussed the requirement in the proposed standard for the auditor to assess the risk that the control might not be effective and, if not effective, the risk that a material weakness would result for each control the auditor selected for testing. Commenters suggested that this requirement conflicted with both current practice and the requirements within the interim standards for the financial statement audit, which involve risk assessment at the financial statement assertion level. These commenters believed that this requirement would result in risk assessments at both the assertion level and the individual control level and suggested that assessing (and documenting) risk at the relevant assertion level is sufficiently precise to drive appropriate audits. Furthermore, they believed that a specific requirement to assess risk at the individual control level and its associated documentation requirement would be unnecessary. After considering these comments, the Board continues to believe that the auditor may vary the nature, timing, and extent of testing based on the assessed risk related to a control. Making this assessment a presumptively mandatory requirement, as it was in the proposed standard, however, does not appear necessary to achieve the intended benefits of varied testing based on the risk associated with a control. Auditing Standard No. 5, therefore, requires the auditor to assess the risk related to the relevant assertion, but not the risk at the individual control level. The standard permits the auditor to consider the risk at the control level, however, and alter the nature, timing, and extent of testing accordingly. Several commenters expressed concern about the advisability of taking a risk-based approach and the adequacy of the Board's interim standards regarding risk assessment. These commenters suggested that auditors have frequently been unsuccessful at applying a risk-based approach to the financial statement audit in the past. The Board has found the arguments for a more principles-based approach to internal control auditing convincing, and the principle that the auditor should vary the testing to respond to the risk is one of the most important in the standard. Early implementation of Auditing Standard No. 2 demonstrated that, when internal control is audited without adequate consideration of risk, the areas that pose the greatest danger of material misstatement may be obscured or lost. The emphasis on risk, therefore, drives an audit that is more effective and focused. While the Board believes that auditors can appropriately assess risk based on the interim auditing standards, it has committed to examining the existing standards in this area to see where improvements can be made. This is currently one of the Board's standard setting priorities. Evaluation of Deficiencies The Board received a substantial number of comments on the topic of evaluating deficiencies, including comments on the proposed definitions of material weakness and significant deficiency, the “strong indicators” of a material weakness, and the requirement to evaluate all identified deficiencies. While a number of commenters stated that auditors do identify material weaknesses in the absence of an actual material misstatement, some noted that, in many cases, material weaknesses are identified only when material misstatements are discovered. Several commenters suggested that the proposed standard, with its focus on using a top-down approach and scoping to identify material weaknesses, would allow auditors to do a more thorough review of the most important controls with less effort expended on reviewing lower risk controls. These commenters often stated that this approach should increase the likelihood of the auditor detecting material weaknesses before a material misstatement occurs. Definition of a Material Weakness The proposed standard retained the basic framework in Auditing Standard No. 2 that described material weaknesses by reference to the likelihood and magnitude of a potential misstatement. While the Board believed that framework to be sound, it made an effort to clarify the definition in the proposed standard by replacing the reference to “more than remote likelihood” with “reasonable possibility.” Financial Accounting Standards Board (“FASB”) Statement No. 5 describes the likelihood of a future event occurring as “probable,” “reasonably possible,” or “remote.” The definition in Auditing Standard No. 2 referred to a “more than remote” likelihood of a misstatement occurring. In accordance with FASB Statement No. 5, the likelihood of an event is “more than remote” when it is either “reasonably possible” or “probable.” As the Board noted in the proposing release, however, some auditors and issuers have misunderstood the term “more than remote” to mean something significantly less likely than a reasonable possibility. This, in turn, could have caused these issuers and auditors to evaluate the likelihood of a misstatement at a much lower threshold than the Board intended. Because the term “more than remote” could have resulted in auditors and issuers evaluating likelihood at a more stringent level than originally intended, the Board proposed changing the definition to refer to a “reasonable possibility.” Commenters on this change were split between those that felt the change would reduce unnecessary effort spent on identifying and analyzing deficiencies, and those who believed it would not. Several commenters noted that the replacement of the term “more than remote likelihood” with the term “reasonable possibility” does not raise the auditor's threshold for classifying deficiencies. According to those commenters, the change simply attempts to align the description of the threshold for identifying deficiencies with previous guidance issued by the PCAOB. The Board continues to believe that the proposed definition—as well as Auditing Standard No. 2—established an appropriate threshold for the likelihood part of the definition of material weakness. While the Board agrees that, as a definitional matter, “reasonable possibility” and “more than remote” describe the same threshold, it believes that “reasonable possibility” describes that threshold more appropriately and clearly, and will therefore avoid the misunderstanding of the threshold created by the way it was described in Auditing Standard No. 2. As a result, it retained that term in the final definition in the standard. In addition, some commenters noted that the definitions of material weakness and significant deficiency in the proposed standard, like the definitions in Auditing Standard No. 2, referred to the likelihood of a material misstatement in both the interim and annual financial statements. Most of these commenters suggested that the Board remove the term “interim” from the definitions of material weakness and significant deficiency because, according to the commenters, it causes confusion when scoping the audit of internal control and unnecessarily complicates the evaluation of deficiencies, particularly in the absence of guidance from the SEC and FASB regarding interim materiality. Some commenters, however, said that the Board should not remove the term “interim” from the definitions because the evaluation of deficiencies should be performed to consider the effectiveness of internal control for both the interim and annual financial statements. After carefully considering these comments, and in order to use the same definition that the SEC uses in its guidance to management, the Board determined to retain the reference to interim financial statements in the final definition of material weakness. 22 22 The provisions in the final standard relating to significant deficiencies are discussed above. As discussed above, the Board also made minor wording changes to the definition of material weakness in order to use the same definition as the SEC in its guidance to management and related rules. Indicators of a Material Weakness The proposed standard described circumstances that should be regarded as strong indicators of a material weakness in internal control. The proposing release noted that the identification of one of these strong indicators should bias the auditor toward a conclusion that a material weakness exists but does not require the auditor to reach that conclusion. Under the proposal, the auditor could determine that these circumstances do not rise to the level of a material weakness, and in some cases, are not deficiencies at all. Many commenters supported the proposed changes from Auditing Standard No. 2 relating to strong indicators, agreeing that, by allowing greater use of professional judgment in this area, practice will improve. A few commenters stated that these changes may lead to some inconsistency in practice, but consistent with other commenters, they still supported the use of greater professional judgment in the evaluation of deficiencies. At least one commenter suggested that several of the strong indicators were not indicators of a material weakness but should be, under all circumstances, a material weakness. A few commenters also suggested that the list of strong indicators in Auditing Standard No. 2 actually stifles the auditor's judgment to the point that auditors fail to identify material weaknesses that exist because the deficiency is not on the list of strong indicators. These commenters suggested that removing the list of strong indicators entirely would be best. The Board believes that auditor judgment is imperative in determining whether a deficiency is a material weakness and that the standard should encourage auditors to use that judgment. At the same time, the Board continues to believe that highlighting certain circumstances that are indicative of a material weakness provides practical information about the application of the standard. As a result, the Board has included this information in the final standard but has taken a more principles-based approach. Additionally, the Board has coordinated with the SEC so that the indicators in the auditing standard parallel those in the SEC's management guidance. Rather than referring to “strong indicators,” the final standard refers simply to “indicators” of material weakness. 23 The standard also makes clear that the list of indicators is not exhaustive and should not be used as a checklist. Specifically, under the final standard, the presence of one of the indicators does not mandate a conclusion that a material weakness exists. At the same time, a deficiency that is not a listed indicator may be a material weakness. 23 The Board included as an indicator the proposed standard's requirement to determine the level of assurance that would satisfy prudent officials in the conduct of their own affairs that they have reasonable assurance that transactions are recorded as necessary to permit the preparation of financial statements in conformity with generally accepted accounting principles. In the proposal, if the auditor determined that a deficiency would prevent prudent officials from concluding that they have such reasonable assurance, the auditor was required to deem the deficiency to be at least a significant deficiency. Under the final standard, if the auditor determines that a deficiency might prevent prudent officials from concluding that they have such reasonable assurance, this circumstance is an indicator of material weakness. The Board did not adopt as indicators in the final standard certain proposed strong indicators. The Board believes, as at least one commenter suggested, that some of these proposed strong indicators are better characterized as material weaknesses rather than as indicators of a material weakness. 24 Including them in the list of indicators, as adopted, would therefore be inconsistent with the degree of judgment required to evaluate whether an indicator of a material weakness is, under particular facts and circumstances, a material weakness. 24 One such proposed strong indicator was an ineffective control environment. Under the proposal, indicators of an ineffective control environment included identification of fraud on the part of senior management and significant deficiencies that have been communicated to management and the audit committee and remain uncorrected after some reasonable period of time. The final standard includes the identification of fraud on the part of senior management as an indicator of a material weakness. In order to simplify the list and make it more principles-based, as well as to align it with the SEC management guidance, however, the Board did not include significant deficiencies that remain uncorrected as an indicator in the final standard. Requirement To Evaluate All Identified Deficiencies The proposed standard required the auditor to evaluate the severity of each control deficiency that comes to his or her attention. The same provision in the proposed standard made clear, however, that the auditor need not scope the audit to find control deficiencies that are less severe than material weaknesses. A few commenters believed that this requirement is not necessary and suggested that an acceptable alternative would be for the auditor to verify that management has evaluated all deficiencies. The Board continues to believe that the auditor needs to evaluate all deficiencies that come to his or her attention. Without such an evaluation, there would not be a sufficient basis for the auditor's opinion. Additional Scoping and Materiality Issues The proposed standard clarified that the auditor should plan and perform the audit of internal control using the same materiality measures used to plan and perform the audit of the annual financial statements. This direction was intended to address concerns that auditors have interpreted Auditing Standard No. 2 as directing them to search for potential defects in internal control at a lower materiality level than that used in the audit of the annual financial statements. The Board received many comments on materiality and scoping, and a large portion of the commenters expressed support for the proposed standard's approach. Some commenters, however, recommended providing clear quantitative guidelines for calculating materiality. Other commenters expressed concern about such an approach, fearing that material areas would be inappropriately excluded from the audit scope. Finally, some commenters suggested that the Board should provide additional guidance on scoping and extent of control testing decisions, such as guidance on sample sizes related to testing of high-risk controls versus low-risk controls or more specific guidance on the scope of the internal control audit for entities with multiple locations. 25 25 The proposed standard focused on the auditor's assessment of risk of material misstatement and how the auditor could carry that assessment process into the scoping of a multi-location audit. Commenters were very supportive of the Board's approach in this area and, consequently, the Board has determined to adopt these provisions as proposed. After considering these comments, the Board has determined to adopt its discussion of materiality in the internal control audit as proposed. The Board believes that the auditing standard on internal control is an inappropriate place to redefine or refine the meaning of materiality, which is a long-established concept in the federal securities laws. With respect to requests for more specific guidance on scoping or extent of testing issues, the Board has, as discussed above, endeavored to adopt a standard that relies more on general principles than detailed requirements. Accordingly, the Board believes that auditors should make specific determinations of how to comply with the general scoping and testing requirements in the standard using professional judgment in the particular circumstances presented. Scaling the Audit for Smaller Companies As discussed above, the Board received many comments on the proposed section on scaling the audit from commenters with a variety of perspectives. The comments covered a wide range of issues. In addition to the matters discussed above, commenters suggested: • That the proposed section on scalability should be focused more closely on how complexity relates to a risk-based audit; • That the proposed standard did not provide sufficient flexibility for smaller companies and that the standard should provide for more “credit” for control testing based on work done as part of the financial statement audit; • That the resulting costs of these proposed changes would need to be studied for several years to determine if they are appropriate; • That the attributes of smaller, less complex companies that were included in the proposed standard were appropriate and that the tailoring directions for auditors were adequate; • That some of the attributes of smaller, less complex companies that might allow the auditor to tailor the audit might be, instead, risk factors that require more testing; • That the emphasis on entity-level controls might not be appropriate; and • That the Board's project to develop guidance on auditing internal control in smaller public companies is necessary. As discussed above, the Board made several changes in response to comments in the final standard. The new standard provides direction on how to tailor internal control audits to fit the size and complexity of the company being audited. It does so by including notes throughout the standard on how to apply the principles in the standard to smaller, less complex companies, and by including a discussion of the relevant attributes of smaller, less complex companies as well as less complex units of larger companies. The Board believes that the final standard appropriately considers the circumstances of smaller and less complex public companies (and other companies with less complex business units) while requiring a high-quality audit regardless of company size or complexity. The planned guidance on this topic will provide additional practical information for auditors of smaller companies. Information Technology Principles In gaining an understanding of the effect of information technology (“IT”) on internal control over financial reporting and the risks the auditor should assess, the proposed standard directed the auditor to apply guidance in AU sec. 319, *Consideration of Internal Control in a Financial Statement Audit* . Additionally, the proposed standard included a discussion of IT operations at smaller and less complex companies. A number of commenters discussed the importance of IT risks to determining the scope of the audit and recommended that the final standard include additional guidance on how the risk assessment related to IT is incorporated in the audit of internal control. In response to these comments, the Board included in Auditing Standard No. 5 a note to paragraph 36 that clarifies that the identification of risks and controls within IT should not be a separate evaluation but, rather, an integral part of the auditor's top-down risk assessment, including identification of significant accounts and disclosures and their relevant assertions, as well as the controls to test. Roll-forward Procedures The proposed standard discussed the procedures the auditor should perform to obtain additional evidence concerning the operation of the control when the auditor reports on the effectiveness of the control “as of” a specific date, but has tested the effectiveness of the control at an interim date. The Board received a few comments on this topic, mainly from auditors. The comments were consistent in their view that the proposed standard improperly implies, by using the expression “if any” in relation to additional evidence the auditor is required to obtain, that the auditor may not need to do any roll-forward work. Commenters suggested that such an approach would be inconsistent with paragraph .99 of AU sec. 319 and suggested that the words “if any” be removed from the final standard. The Board believes that its standard should be consistent with AU sec. 319.99 in that the auditor should perform some level of roll-forward procedures. Consequently, the Board removed the words “if any” from the relevant paragraphs of Auditing Standard No. 5 to correct the inconsistency. The Board also noted that, in some circumstances, inquiry alone might be a sufficient roll-forward procedure. Cumulative Knowledge and Rotation The proposed standard on auditing internal control allowed the auditor to incorporate knowledge from previous years' audits into his or her decision making process for determining the nature, timing, and extent of testing necessary. The section in the proposed standard on special considerations for subsequent years' audits built upon the risk-based framework in the proposed standard for determining the nature, timing, and extent of testing by describing certain additional factors for the auditor to evaluate in subsequent years. These factors included the results of prior years' testing and any change that may have taken place in the controls or the business since that testing was performed. This section retained the requirement in Auditing Standard No. 2 that each control deemed important to the auditor's conclusion be tested every year, but allowed for a reduction in testing when the additional risk factors indicated that the risk was lower than in the past. Many commenters strongly supported these provisions as proposed. Many investors, in particular, stated that while they supported the proposed approach, they would not be supportive of rotation of control testing over a multiple-year period. These commenters were generally concerned that rotation of control testing would negatively affect audit quality. Among supporters of the approach in the proposed standard, several requested further clarification in the standard or additional guidance on how this approach should affect the level of testing. Many issuers suggested that the standard should allow for full rotation—which exempts some important controls from testing each year—of at least controls in low-risk areas. Other commenters recommended that all controls should be tested on a multi-year rotating basis. These comments often focused on the fact that while the proposed standard required the auditor to evaluate whether there had been any relevant changes since the control was tested, it still required testing at some level even when there had been no change. These commenters considered this requirement to be unnecessary. The Board shares the concern that multi-year rotation of control testing would not provide sufficient evidence for the auditor's opinion on internal control effectiveness, which is required by the Act to be issued each year. In the financial statement audit, control testing plays a supporting role—to the extent that controls have been tested and are effective, the auditor can reduce the level of (but not eliminate) the necessary substantive testing. In contrast, in the internal control audit, control testing does not play a supporting role but is the sole basis for the auditor's opinion. Additionally, even if the design of the control and its related process does not change from the prior year, it is not possible to assess the control's operating effectiveness without performing some level of testing. For these reasons, rotation is not a viable option in the audit of internal control. Instead, the approach described in the proposed standard has been clarified in the final standard and continues to focus the auditor on relevant changes since a particular control was last tested, as many commenters suggested. Under this approach, the auditor would consider, in addition to the risk factors described in the standard that are always relevant to determining the nature, timing, and extent of testing, whether there has been a change in the controls or in the business that might necessitate a change in controls; the nature, timing, and extent of procedures performed in previous audits; and the results of the previous years' testing of the control. 26 After taking into account these additional factors, the additional information in subsequent years' audits might permit the auditor to assess risk as lower than in the initial year and, thus, might permit the auditor to reduce testing. 26 *See* paragraph 55. This treatment of cumulative knowledge is analogous to the roll-forward provisions in the final standard. In the case of subsequent years, the auditor, in essence, rolls forward the prior years' testing when the control was found to be effective in the past and no change has occurred (or would have been expected to occur due to changes in the environment or process that contains the control). Because the auditor might be able to assess the risk lower in the subsequent years, a walkthrough, or equivalent procedures, might be sufficient for low-risk controls. This approach appropriately factors in the effect of cumulative knowledge, while maintaining audit quality and providing a sufficient basis for the auditor's opinion. Reporting the Results of the Audit In the proposed standard, the Board attempted to address concerns that the separate opinion on management's assessment required by Auditing Standard No. 2 contributed to the complexity of the standard and caused confusion regarding the scope of the auditor's work. 27 Accordingly, to emphasize the proper scope of the audit and to simplify the reporting, the proposed standard required that the auditor express only one opinion on internal control—a statement of the auditor's opinion on the effectiveness of the company's internal control over financial reporting. The proposal eliminated the separate opinion on management's assessment because it was redundant of the opinion on internal control itself and because the opinion on the effectiveness of controls more clearly conveys the same information—specifically, whether the company's internal control is effective. 27 Although Auditing Standard No. 2 requires the auditor to evaluate management's process, the auditor's opinion on management's assessment is not an opinion on management's internal control evaluation process. Rather, it is the auditor's opinion on whether management's statements about the effectiveness of the company's internal controls are fairly stated. Many commenters agreed with the Board that eliminating the separate opinion on management's assessment would reduce confusion and clarify the reporting. Some commenters, however, suggested that the Board should instead require only an opinion on management's assessment. These commenters expressed their belief that the Act requires only that the auditor review management's assessment process and not the company's internal control. Additionally, a few commenters expressed confusion about why the proposed standard continued to reference an audit of management's assessment in paragraph 1 of the proposed standard and the auditor's report. The Board has determined, after considering these comments, to adopt the provision requiring only an opinion on internal control. 28 The Board continues to believe that the overall scope of the audit that was described by Auditing Standard No. 2 and the proposed standard is correct; that is, to attest to and report on management's assessment, as required by Section 404(b) of the Act, the auditor must test controls directly to determine whether they are effective. 29 Accordingly, paragraphs 1 and 2 of the proposed standard provided that the auditor audits management's assessment—the statement in management's annual report about whether internal control is effective—by auditing whether that statement is correct—that is, whether internal control is, in fact, effective. The final standard similarly makes this clear. In response to commenters, however, the Board has clarified the auditor's report so that it will consistently refer to the required audit as the audit of internal control. 28 The SEC has adopted changes to its rules that require the auditor to express an opinion directly on internal control. 29 In addition, Section 103 of the Act requires the Board's standard on auditing internal control to include “testing of the internal control structure and procedures of the issuer * * *.” Under Section 103, the Board's standard also must require the auditor to present in the audit report, among other things, “an evaluation of whether such internal control structure and procedures * * * provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles * * *.” Implementation Some commenters urged the Board to focus on implementation issues after it adopts a final standard, and noted that effective implementation by the Board is crucial to the internal control reporting process. Some of these commenters focused on the inspections process, which they suggested is key to promoting audit efficiency. Some stated that auditors would be unlikely to change their audit approach until they are confident that the inspections will be similarly focused. The Board is committed to effective monitoring of firms' compliance with the new standard and will continue to promote proper implementation through other means, including the Board's Forums on Auditing in the Small Business Environment and guidance for auditors of smaller companies. III. Date of Effectiveness of the Proposed Rules and Timing for Commission Action Within 35 days of the date of publication of this notice in the **Federal Register** or within such longer period
(i)As the Commission may designate up to 90 days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding or
(ii)as to which the Board consents, the Commission will:
(a)By order approve such proposed rule; or
(b)Institute proceedings to determine whether the proposed rule should be disapproved. IV. Solicitation of Comments Interested persons are invited to submit written data, views and arguments concerning the foregoing, including whether the proposed rules are consistent with the Act. Comments may be submitted by any of the following methods: Electronic Comments • Use the Commission's Internet comment form ( *http://www.sec.gov* ); or • Send an e-mail to *rule-comments@sec.gov* . Please include File Number PCAOB-2007-02 on the subject line. Paper Comments • Send paper comments in triplicate to Nancy M. Morris, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090. All submissions should refer to File No. PCAOB-2007-02. This file number should be included on the subject line if e-mail is used. To help process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site ( *http://www.sec.gov* ). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Section, 100 F Street, NE., Washington, DC 20549. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Number PCAOB-2007-02. In light of the significant public interest in the implementation of section 404 of the Sarbanes-Oxley Act, the Commission is providing a 30-day comment period. Comments should be submitted on or before July 12, 2007. The Commission intends to act on the proposed rule no later than 45 days after publication in the **Federal Register** . By the Commission. Florence E. Harmon, Deputy Secretary. [FR Doc. E7-11311 Filed 6-11-07; 8:45 am] BILLING CODE 8010-01-P SECURITIES AND EXCHANGE COMMISSION [Release No. 34-55865; File No. SR-Amex-2007-51] Self-Regulatory Organizations; American Stock Exchange LLC; Notice of Filing and Immediate Effectiveness of Proposed Rule Change Relating to Backup Trading Arrangements June 6, 2007. Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”) 1 and Rule 19b-4 thereunder, 2 notice is hereby given that on May 21, 2007, the American Stock Exchange LLC (“Amex” or “Exchange”) filed with the Securities and Exchange Commission (“Commission”) the proposed rule change as described in Items I and II below, which Items have been substantially prepared by the Exchange. The Exchange filed the proposed rule change as a “noncontroversial” rule change under Rule 19b-4(f)(6) under the Act, 3 which renders the proposal effective upon filing with the Commission. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons. 1 15 U.S.C. 78s(b)(1). 2 17 CFR 240.19b-4. 3 17 CFR 240.19b-4(f)(6). I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change The Exchange seeks to adopt new rules authorizing the Amex to enter into arrangements with one or more other exchanges which would provide for backup trading facilities for Amex listed options on another exchange if the Amex's facility becomes disabled and is unavailable for trading. The proposed rules further provide for the availability of Amex trading facilities to another exchange to trade its listed options if that exchange's facility becomes disabled. The text of the proposed rule change is available on the Amex's Web site ( *http://www.amex.com* ), at Amex's principal office, and at the Commission's Public Reference Room. II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change In its filing with the Commission, the Exchange included statements concerning the purpose of and basis for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. Amex has prepared summaries, set forth in sections A, B, and C below, of the most significant aspects of such statements. A. Self-Regulatory Organization's Statement of the Purpose of, and the Statutory Basis for, the Proposed Rule Change 1. Purpose The Amex proposes to adopt new Amex Rule 62 governing Backup Trading Arrangements. Proposed new Rule 62 sets forth procedures whereby Amex members and associated persons may use a Backup Exchange's facilities to conduct the trading of some or all of its Exclusively and Singly Listed Options for the duration of a disabling event. The Amex will provide for another exchange (a “Disabled Exchange”) to trade its Exclusively and Singly Listed Options in the event they are unable to do so because of an emergency or extraordinary set of circumstances that severely and adversely affects its ability to trade (a “Disabling Event”). The Amex Is the Disabled Exchange Proposed Rule 62(a)(i) governs the trading of Exclusively Listed Options (“Exclusively Listed Options” or “ELOs”) if the Amex is the Disabled Exchange. The term “exclusively listed option” is defined as an option that is listed exclusively by an exchange (because such exchange has an exclusive license to use, or has proprietary rights in, the interest underlying the option). Proposed Rule 62(a)(i)(B) provides that the Amex may enter into arrangements with one or more other exchanges (each a “Backup Exchange”) to permit the Amex and its members and associated persons and other personnel to use a portion of the Backup Exchange's facilities to conduct the trading of some or all of the Amex's Exclusively Listed Options if there were a Disabling Event. Such options shall trade as listings of Amex and the facility of the Backup Exchange used by the Amex for this purpose will be deemed to be a facility of the Amex. The Exchange's proposal further provides that the trading of Amex Exclusively Listed Options shall be conducted in accordance with the rules of the Backup Exchange. In addition, the Amex and the Backup Exchange may agree that other rules of the Amex will apply to such trading. The Backup Exchange rules that govern trading on Amex's facility at the Backup Exchange shall be deemed to be Amex rules for purposes of such trading. According to the Exchange's proposal, the Backup Exchange shall perform the related regulatory functions with respect to trading of Amex Exclusively Listed Options on the Amex's facility at the Backup Exchange, except as the Amex and the Backup Exchange may specifically agree otherwise. The Backup Exchange and the Amex shall coordinate with each other regarding surveillance and enforcement respecting trading of the Exclusively Listed Options on the Amex's facility at the Backup Exchange. If the Backup Exchange is unable to accommodate all Amex members that desire to trade on Amex's facility at the Backup Exchange, the Amex may determine which members shall be eligible to trade at that facility. Factors the Amex shall consider in making such determinations may include, but are not limited to, any one or more of the following: Whether the member is a specialist in the applicable product, the number of contracts traded by the member or member organization in the applicable product, market performance, and other factors relating to a member's contribution to the market in the applicable product or products during a specific period. The Exchange's proposal further provides that the members of the Backup Exchange shall not be authorized to trade in any Amex Exclusively Listed Options, except that the Amex may deputize willing floor brokers of the Backup Exchange as temporary Amex members to permit them to execute orders as brokers in the Amex Exclusively Listed Options traded on the Amex's facility at the Backup Exchange. Furthermore, the Backup Exchange has agreed that it will, at the instruction of Amex, select members of the Backup Exchange that are willing to be deputized by the Amex as temporary Amex members authorized to trade Amex Exclusively Listed Options on the Amex's facility at the Backup Exchange for a period of time following a Disabling Event as the Amex determines to be appropriate, and the Amex may deputize such members of the Backup Exchange as temporary Amex members for that purpose. The Exchange's proposal further provides that options listed by the Backup Exchange that do not satisfy the standard listing and maintenance criteria of the Backup Exchange will be subject, upon listing by the Backup Exchange, to delisting (and, thus, restrictions on opening new series, and engaging in opening transactions in those series with open interest, as may be provided in the rules of the Backup Exchange). Proposed Rule 62(a)(ii) governs the trading of singly listed options (a “Singly Listed Option” or “SLO”). A Singly Listed Option is defined as an option that is not an Exclusively Listed Option, but that is listed by an exchange and not by any other national securities exchange. Proposed Rule 62(a)(ii) provides that the Amex may enter into arrangements with a Backup Exchange under which the Backup Exchange will agree, in the event of a Disabling Event, to list for trading Singly Listed Options that are then singly listed only by the Amex and not by the Backup Exchange. The proposed Rule further provides that any such options listed by the Backup Exchange shall trade on the Backup Exchange and in accordance with the rules of the Backup Exchange. Such options shall be traded by members of the Backup Exchange and by Amex members selected by the Amex to the extent the Backup Exchange can accommodate Amex members in the capacity of temporary members of the Backup Exchange. If the Backup Exchange is unable to accommodate all Amex members that desire to trade at the Backup Exchange, the Amex may determine which of its members shall be eligible to trade at the Backup Exchange. Any Amex member who is granted temporary access to the Backup Exchange pursuant to this paragraph shall only be permitted to act in those Backup Exchange capacities that are authorized by the Backup Exchange and that are comparable to capacities in which the temporary member has been authorized to act on the Amex, and to trade in those options in which the temporary member is authorized to trade on the Amex. Finally, Singly Listed Options listed by the Backup Exchange that do not satisfy the standard listing and maintenance criteria of the Backup Exchange will be subject, upon listing by the Backup Exchange, to delisting (and, thus, restrictions on opening new series, and engaging in opening transactions in those series with open interest, as may be provided in the rules of the Backup Exchange). The Amex Is the Backup Exchange Proposed Rule 62(b)(i) provides that the Amex may enter into arrangements with one or more other Disabled Exchanges to allow the Disabled Exchange and its members to use a portion of the Amex's facilities to conduct the trading of some or all of the Disabled Exchange's Exclusively Listed Options in the event of a Disabling Event. Proposed paragraph
(B)provides that the trading of the Disabled Exchange's Exclusively Listed Options on the Disabled Exchange's facility at the Amex shall be conducted in accordance with Amex rules. The members of the Disabled Exchange that are trading on the Disabled Exchange's facility at the Amex (not including Amex members who become temporary members of the Disabled Exchange) will be subject to the rules of the Disabled Exchange governing or applying to the maintenance of a person's or a firm's status as a member of the Disabled Exchange. In addition, the Disabled Exchange and the Amex may agree that other Disabled Exchange rules will apply to such trading. The Disabled Exchange and the Amex have agreed to communicate to their respective members which rules apply in advance of trading. Proposed paragraph
(C)provides that the Amex will perform the related regulatory functions with respect to trading of the Disabled Exchange's Exclusively Listed Options on the Disabled Exchange's facility at the Amex, in each case except as the Disabled Exchange and the Amex may specifically agree otherwise. The Amex and the Disabled Exchange have agreed to coordinate with each other regarding surveillance and enforcement respecting trading of the Disabled Exchange's Exclusively Listed Options on the Disabled Exchange's facility at the Amex. The Disabled Exchange has agreed that it shall retain the ultimate legal responsibility for the performance of its self-regulatory obligations with respect to the Disabled Exchange's facility at the Amex. Proposed paragraph
(D)provides the Amex members shall not be authorized to trade in any Exclusively Listed Options of the Disabled Exchange, except that:
(1)The Disabled Exchange may deputize willing Amex floor brokers as temporary members of the Disabled Exchange to permit them to execute orders as brokers in Exclusively Listed Options of the Disabled Exchange traded on the facility of the Disabled Exchange at the Amex; and
(2)at the instruction of the Disabled Exchange, the Amex shall select Amex members that are willing to be deputized by the Disabled Exchange as temporary members of the Disabled E xchange authorized to trade the Disabled Exchange's Exclusively Listed Options on the facility of the Disabled Exchange at the Amex for such period of time following a Disabling Event as the Disabled Exchange determines to be appropriate, and the Disabled Exchange may deputize such Amex members as temporary members of the Disabled Exchange for that purpose. Proposed paragraph (b)(ii) provides that the Amex may enter into arrangements with a Disabled Exchange under which the Amex will agree, in the event of a Disabling Event, to list for trading options that are then singly listed only by the Disabled Exchange and not by the Amex. Singly Listed Options listed by the Amex shall trade on the Amex and in accordance with Amex rules. Such options shall be traded by Amex members and by members of the Disabled Exchange selected by the Disabled Exchange to the extent the Amex can accommodate members of the Disabled Exchange in the capacity of temporary members of Amex. Any member of a Disabled Exchange granted temporary access to conduct business on the Amex under this paragraph shall only be permitted to act in those Amex capacities that are authorized by the Amex, and that are comparable to capacities in which the temporary member has been authorized to act on the Disabled Exchange and to trade in those options in which the temporary member is authorized to trade on the Disabled Exchange. Classes of options listed by the Amex that does not satisfy Amex listing and maintenance criteria will be subject, upon listing by the Amex, t delisting (and, thus, restrictions on opening new series, and engaging in opening transactions in those series with open interest, as may be provided in Amex rules.) Temporary Members of the Disabled Exchange and the Backup Exchange Paragraph
(c)of proposed Rule 62 governs the member obligations of both the temporary members of the Disabled Exchange and the temporary members of the Backup Exchange. Proposed paragraph
(A)provides that an Amex member acting as a temporary member of the Disabled Exchange shall be subject to, and obligated to comply with, the rules that govern the operation of the facility of the Disabled Exchange at the Amex to the extent applicable during the period of such trading. Such Amex member shall have none of the rights of a member of the Disabled Exchange except the right to conduct business on the facility of the Disabled Exchange at the Amex as described in the Exchange's proposal herein. Additionally, the member organization associated with such Amex member, if any, shall be responsible for all obligations arising out of that Amex member's activities on or relating to the Disabled Exchange. Finally, the proposed rule provides that the clearing member of such Amex member shall guarantee and clear the transactions of such Amex member on the Disabled Exchange. Similarly, the Exchange's proposal provides that a member of the Backup Exchange acting in the capacity of a temporary member of the Amex pursuant to proposed paragraph (a)(i)(F) shall be subject to, and obligated to comply with, the rules that govern the operation of the facility of the Amex at the Backup Exchange, including Amex rules to the extent applicable during the period of such trading. The proposed rule further provides that temporary members shall have none of the rights of an Amex member except the right to conduct business on the facility of Amex at the Backup Exchange as described herein. In addition, the member organization associated with such temporary member, if any, shall be responsible for all obligations arising out of that temporary member's activities on or relating to the Amex and the clearing member of such temporary member shall guarantee and clear the transactions on the Amex of such temporary member. Proposed paragraph (c)(ii)(A) provides that an Amex member acting in the capacity of a temporary member of the Backup Exchange pursuant to paragraph (a)(ii)(B) shall be subject to, and obligated to comply with, the rules of the Backup Exchange that are applicable to the Backup Exchange's own members. Such Amex member shall have none of the rights of a member of the Backup Exchange except the right to conduct business on the Backup Exchange to the extent described in the proposed Rule. The member organization associated with such Amex member, if any, shall be responsible for all obligations arising out of that Amex member's activities on or relating to the Backup Exchange. Furthermore, the clearing member of such Amex member shall guarantee and clear the transactions of such Amex member on the Backup Exchange. Finally, such Amex member shall only be permitted to act in those capacities on the Backup Exchange that are authorized by the Backup Exchange and that are comparable to capacities in which the Amex member has been authorized to act on the Amex, and to trade in those options in which the Amex member is authorized to trade on the Amex. A member of Disabled Exchange acting in the capacity of a temporary member of the Amex pursuant to paragraph (b)(ii)(A) shall be subject to, and obligated to comply with, Amex rules that are applicable to Amex's own members. Such temporary member shall have none of the rights of an Amex member except the right to conduct business on the Amex to the extent described in the proposed Rule. The member organization associated with such temporary member, if any, shall be responsible for all obligations arising out of that temporary member's activities on or relating to the Amex. The clearing member of such temporary member shall guarantee and clear the transactions of such temporary member on the Amex and such temporary member shall only be permitted to act in those Amex capacities that are authorized by the Amex and that are comparable to capacities in which the temporary member has been authorized to act on the Disabled Exchange, and to trade in those option classes in which the temporary member is authorized to trade on the Disabled Exchange. Member Proceedings Proposed paragraph
(d)governs member proceedings that may take place regarding trading during a backup period. Proposed paragraph (d)(i) provides that if the Amex initiates an enforcement proceeding with respect to the trading during a backup period of the Singly Listed Options of the Disabled Exchange by a temporary member of the Amex or the Exclusively Listed Options of the Disabled Exchange by a member of the Disabled Exchange (other than an Amex member who is a temporary member of the Disabled Exchange), and such proceeding is in process upon the conclusion of the backup period, the Amex may transfer responsibility for such proceeding to the Disabled Exchange following the conclusion of the backup period. Moreover, arbitration of any disputes with respect to any trading during a backup period of Singly Listed Options of the Disabled Exchange or of Exclusively Listed Options of the Disabled Exchange on the Disabled Exchange's facility at the Amex will be conducted in accordance with Amex rules, unless the parties to an arbitration agree that it shall be conducted in accordance with the rules of the Disabled Exchange. Proposed Rule 62(d)(ii) provides that if the Backup Exchange initiates an enforcement proceeding with respect to the trading during a backup period of Amex Singly Listed Options by a temporary member of the Backup Exchange or Amex Exclusively Listed Options by an Amex member (other than a member of the Backup Exchange who is a temporary member of the Amex), and such proceeding is in process upon the conclusion of the backup period, the Backup Exchange may transfer responsibility for such proceeding to the Amex following the conclusion of the backup period. Furthermore, arbitration of any disputes with respect to any trading during a backup period of Amex Singly Listed Options on the Backup Exchange or of Amex Exclusively Listed Options on the facility of the Amex at the Backup Exchange will be conducted in accordance with the rules of the Backup Exchange, unless the parties to an arbitration agree that it shall be conducted in accordance with Amex rules. Finally, the proposed rule provides that Amex members are required to take appropriate actions as instructed by the Exchange to accommodate the Amex's backup trading arrangements. 2. Statutory Basis The proposed rule change is consistent with Section 6(b) 4 of the Act in general and furthers the objectives of Section 6(b)(5) 5 in particular in that it is designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest; and is not designed to permit unfair discrimination between customers, issuers, brokers, or dealers, or to regulate by virtue of any authority conferred by the Act matters not related to the purpose of the Act or the administration of the Exchange. 4 15 U.S.C. 78f(b). 5 15 U.S.C. 78f(b)(5). B. Self-Regulatory Organization's Statement on Burden on Competition The proposed rule change does not impose any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act. C. Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants or Others No written comments were solicited or received with respect to the proposed rule change. III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action Because the proposed rule change:
(i)Does not significantly affect the protection of investors or the public interest;
(ii)does not impose any significant burden on competition; and
(iii)by its terms, does not become operative for 30 days after the date of filing, the proposed rule change has become effective pursuant to Section 19(b)(3)(A) of the Act 6 and subparagraph (f)(6) of Rule 19b-4 thereunder. 7 As required under Rule 19b-4(f)(6)(iii), 8 the Exchange provided the Commission with written notice of its intent to file the proposed rule change, along with a brief description and text of the proposed rule change, at least five business days prior to the date of the filing of the proposed rule change. 6 15 U.S.C. 78s(b)(3)(A). 7 17 CFR 240.19b-4(f)(6). 8 17 CFR 240.19b-4(f)(6)(iii). Amex has requested that the Commission waive the 30-day operative delay. The Commission believes that waiving the 30-day operative delay is consistent with the protection of investors and the public interest. 9 The Commission notes that the proposed rule change is modeled on a recently approved Philadelphia Stock Exchange proposal. 10 Amex's proposal does not appear to raise any novel regulatory issues and will allow Amex without undue delay to implement backup trading arrangements for options—particularly exclusively listed options—in the event of a Disabling Event. 9 For purposes only of waiving the operative delay for this proposal, the Commission has considered the proposed rule's impact on efficiency, competition, and capital formation. *See* 15 U.S.C. 78c(f). 10 *See* Exchange Act Release No. 51926 (June 27, 2005), 70 FR 38232 (July 1, 2005) (SR-PHLX-2004-65). At any time within 60 days of the filing of the proposed rule change, the Commission may summarily abrogate such rule change if it appears to the Commission that such action is necessary or appropriate in the public interest, for the protection of investors, or otherwise in the furtherance of the purposes of the Act. IV. Solicitation of Comments Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule change is consistent with the Act. Comments may be submitted by any of the following methods: Electronic Comments • Use the Commission's Internet comment form ( *http://www.sec.gov/rules/sro.shtml* ) or • Send an e-mail to *rule-comments@sec.gov* . Please include File Number SR-Amex-2007-51 on the subject line. Paper Comments • Send paper comments in triplicate to Nancy M. Morris, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090. All submissions should refer to File Number SR-Amex-2007-51. This file number should be included on the subject line if e-mail is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site ( *http://www.sec.gov/rules/sro.shtml* ). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room. Copies of such filing also will be available for inspection and copying at the principal offices of the Exchange. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Number SR-Amex-2007-51 and should be submitted on or before July 3, 2007. For the Commission, by the Division of Market Regulation, pursuant to delegated authority. 11 11 17 CFR 200.30-3(a)(12). Florence E. Harmon, Deputy Secretary. [FR Doc. E7-11265 Filed 6-11-07; 8:45 am] BILLING CODE 8010-01-P SECURITIES AND EXCHANGE COMMISSION [Release No. 34-55871; File No. SR-CBOE-2006-84] Self-Regulatory Organizations; Chicago Board Options Exchange, Incorporated; Notice of Filing of Amendment No. 5 to a Proposed Rule Change To List and Trade Credit Default Options; and Order Granting Accelerated Approval of the Proposed Rule Change, as Modified by Amendment Nos. 3, 4, and 5, and Designating Credit Default Options as Standardized Options Under Rule 9b-1 of the Securities Exchange Act of 1934 June 6, 2007. I. Introduction On October 26, 2006, the Chicago Board Options Exchange, Incorporated (“CBOE” or “Exchange”) filed with the Securities and Exchange Commission (“Commission”) a proposed rule change, pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”) 1 and Rule 19b-4 thereunder, 2 to permit CBOE to list and trade cash-settled, binary call options based on credit events in one or more debt securities of an issuer, referred to as credit default options. On December 21, 2006, CBOE filed Amendment No. 1 to the proposed rule change; on January 16, 2007, CBOE filed Amendment No. 2 to the proposed rule change; on February 2, 2007, CBOE filed Amendment No. 3 to the proposed rule change; 3 and on February 7, 2007, CBOE filed Amendment No. 4 to the proposed rule change. The proposed rule change, as amended, was published for comment in the **Federal Register** on February 14, 2007. 4 The Commission received no comments on the proposal. On March 28, 2007, CBOE filed Amendment No. 5 to the proposed rule change (“Amendment No. 5”). This notice and order notices Amendment No. 5; solicits comments from interested persons on Amendment No. 5; approves the proposed rule change, as amended, on an accelerated basis; and designates credit default options as “standardized options” pursuant to Rule 9b-1 under the Act. 5 1 15 U.S.C. 78s(b)(1). 2 17 CFR 240.19b-4. 3 Amendment No. 3 replaced the original filing, as modified by Amendment Nos. 1 and 2, in its entirety. 4 *See* Securities Exchange Act Release No. 55251 (February 7, 2007) (SR-CBOE-2006-84), 72 FR 7091 (“CBOE Proposal”). 5 *See* 17 CFR 240.9b-1. Pursuant to Rule 9b-1(a)(4) under the Act, the Commission may, by order, designate as “standardized options” securities that do not otherwise meet the definition for “standardized options.” Standardized options are defined in Rule 9b-1(a)(4) as: “[O]ptions contracts trading on a national securities exchange, an automated quotations system of a registered securities association, or a foreign securities exchange which relate to options classes the terms of which are limited to specific expiration dates and exercise prices, or such other securities as the Commission may, by order, designate.” 17 CFR 240.9b-1(a)(4). II. Description of the CBOE Proposal A. Generally CBOE proposes to list and trade credit default options, which are cash-settled, binary options 6 that are automatically exercised upon the occurrence of specified credit events or expire worthless. A credit default option would be referenced to the debt securities issued by a specified public company (“Reference Entity”) 7 and would either have a fixed payout or expire worthless, depending upon whether or not a credit event (as described below) occurs during the life of the option. Upon confirmation of a credit event prior to the last day of trading of a credit default option series, 8 the options positions existing as of that time would be automatically exercised and the holders of long options positions would receive a fixed cash payment of $100,000 per contract. 9 If no credit event is confirmed during the life of the option, the final settlement price would be $0. 6 A binary option is a style of option having only two possible payoff outcomes: Either a fixed amount or nothing at all. 7 Proposed CBOE Rule 29.1(f) also includes as a “Reference Entity” the guarantor of the debt security underlying the credit default option. 8 Proposed CBOE Rule 29.9 requires that CBOE confirm the occurrence of a credit event through at least two sources, which may include announcements published via newswire services or information service companies, the names of which would be announced to the membership via a CBOE regulatory circular, or information contained in any order, decree, or notice of filing, however described, of or filed with the courts, the Commission, an exchange, an association, the Options Clearing Corporation (“OCC”), or another regulatory agency or similar authority. 9 The settlement amount would be $100,000 per contract unless adjusted pursuant to proposed CBOE Rule 29.4, as discussed below. Credit events that would trigger automatic exercise include a failure to make payment pursuant to the terms of the underlying debt security and any other event of default specified by CBOE at the time the Exchange initially lists a particular class of credit default options. The events of default that CBOE may specify must be defined in accordance with the terms of the debt security underlying the credit default option (“Reference Obligation”) or any other debt security of the Reference Entity (collectively with the Reference Obligation, “Relevant Obligations”). 10 10 *See* proposed CBOE Rule 29.1(c). B. Listing Standards A credit default option must conform to the initial and continued listing standards under proposed CBOE Chapter XXIX. CBOE may list and trade a credit default option that overlies a debt security of a Reference Entity, provided that such issuer or guarantor, or its parent if a wholly owned subsidiary, has at least one class of securities that is registered under the Act and is an “NMS stock” 11 as defined in Rule 600 of Regulation NMS under the Act. 12 The registered equity securities issued by the Reference Entity also would have to satisfy the requirements of CBOE Rule 5.4 for continued options trading, which requires, among other things, that an equity security underlying an option be itself widely held and actively traded. 13 The requirement that the equity securities of an issuer of a debt security underlying a credit default option meet the criteria of Rule 5.4 is designed to ensure that the issuer's securities enjoy widespread investor interest. The requirement that the Reference Entity be an issuer of a registered NMS stock will help ensure that investors have access to comprehensive public information about the issuer, including the registration statement filed under the Securities Act of 1933 (“Securities Act”) and other periodic reports. 14 11 “NMS stock” means any security, or class of securities, other than an option for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transaction in listed options. *See* 17 CFR 242.600(b)(46) and (47). 12 *See* proposed CBOE Rule 5.3.11. 13 CBOE Rule 5.4 provides that, absent exceptional circumstances, an underlying security will not be deemed to meet the Exchange's requirements for continued approval when:
(a)There are fewer than 6,300,000 shares of the underlying security held by persons other than those who are required to report their security holdings under Section 16(a) of the Act (15 U.S.C. 78p);
(b)there are fewer than 1,600 holders of the underlying security;
(c)the trading volume (in all markets in which the underlying security is traded) was less than 1,800,000 shares in the preceding twelve months;
(d)the market price per share of the underlying security closed below $3 on the previous trading day as measured by the closing price reported in the primary market in which the underlying security traded; or
(e)the underlying security ceases to be an NMS stock. 14 Section 13 of the Act, 15 U.S.C. 78m, requires that any issuer of a security registered pursuant to Section 12 of the Act, 15 U.S.C. 78 *l* , would file with the Commission annual reports and information and documents necessary to keep reasonably current the information in its Section 12 registration statement. A credit default option could not be exercised at the discretion of the investor, but instead would have an automatic payout only upon the occurrence of a credit event. The expiration date would be the fourth business day after the last day of trading of the series, which would be the third Friday of the expiration month. 15 A credit default option generally would expire up to 123 months from the time it is listed, and the Exchange usually would open one to four series for each year up to 10.25 years from the current expiration. 16 15 If a credit event is confirmed, the expiration date would be the second business day after the confirmation of a credit event. *See* proposed CBOE Rule 29.1(d) and (e). 16 *See* proposed CBOE Rule 29.2(b)(1) and (2). C. Trading Credit default options will trade on CBOE's Hybrid Trading System from 8:30 a.m. to 3 p.m. (Central Time) 17 in a manner similar to the trading of equity options. With limited distinctions, as described more fully in the proposal, CBOE's equity option trading rules will apply to credit default options. 18 Also, credit default options will be eligible for trading as Flexible Exchange Options (“FLEX Options”). A FLEX Option that is a credit default option would be cash-settled and the exercise-by-exception provisions of OCC Rule 805 19 would not apply. Market-makers shall be appointed to credit default options pursuant to CBOE's existing requirements, 20 as supplemented by proposed CBOE Rule 29.17. Additionally, CBOE represents that there will be a maximum of one series per quarterly expiration in a given credit default option class, and that it, and the Options Price Reporting Authority (“OPRA”), have the necessary systems capacity to handle the additional quote volume anticipated to be associated with credit default options. 17 *See* proposed CBOE Rule 29.11. 18 *See* proposed CBOE Rules 29.11-29.17 and 29.19. 19 OCC Rule 805 sets forth the expiration date exercise procedures for options cleared and settled by the OCC. 20 *See* Chapter VIII of CBOE's Rules. Once a particular credit default option class has been approved for listing and trading, the Exchange would, from time to time, open for trading a series of that class. If a credit default option initially approved for trading no longer meets the Exchange's requirements for continued approval, the Exchange would not open for trading any additional series of options and, as provided in CBOE Rule 5.4, could prohibit any opening purchase transactions in such series. The proposed trading rules for credit default options are designed to create an environment that takes into account the small number of transactions likely to occur, while providing price improvement and the transparency benefits of competitive Exchange floor bidding, as compared to the over-the-counter (“OTC”) market. Upon the confirmation of a credit event or the redemption of all Relevant Obligations, the applicable credit default option class would cease trading and all outstanding contracts in that class would be subject to automatic exercise. In addition, the CBOE's trading halt procedures applicable to equity options shall apply to credit default options. 21 When determining whether to institute a trading halt in credit default options, CBOE floor officials would consider whether current quotations for the Relevant Obligation(s) or other securities of the Reference Entity are unavailable or have become unreliable. The Exchange's board of directors shall also have the power to impose restrictions on transactions or exercises in one or more series of credit default options as the board, in its judgment, determines advisable in the interests of maintaining a fair and orderly market or otherwise deems advisable in the public interest or for the protection of investors. 22 21 *See* CBOE Rules 6.3 and 6.3B; proposed CBOE Rule 29.13. 22 *See* proposed CBOE Rule 29.8. D. Clearance and Settlement Because credit default options do not have an exercise price, they do not, by their terms, meet the definition of “standardized options” for purposes of Rule 9b-1 under the Act. 23 However, as discussed herein, the Commission today is using its authority pursuant to Rule 9b-1 to designate credit default options as “standardized options” under Rule 9b-1. Consequently, credit default option transactions would be eligible for clearance and settlement by the OCC in accordance with procedures that are substantially similar to existing systems and procedures for the clearance and settlement of exchange-traded options. 24 23 *See* 17 CFR 240.9b-1. 24 On February 13, 2007, the OCC filed with the Commission pursuant to Section 19(b)(1) of the Act, 15 U.S.C. 78s(b)(1), and Rule 19b-4 thereunder, 17 CFR 240.19b-4, a proposed rule change to enable it to clear and settle credit default options proposed to be listed by CBOE. The proposed rule change was published for comment in the **Federal Register** on February 27, 2007. Securities Exchange Act Release No. 55362, 72 FR 9826 (March 5, 2007). On March 7, 2007, the OCC filed Amendment No. 1 to the proposed rule change. *See* SR-OCC-2007-01 (as amended, the “OCC Proposal”). The Commission has not yet taken action on the OCC proposal. E. Adjustments Credit default options will be subject to adjustments in two circumstances. 25 First, if the original Reference Entity is succeeded by another entity in accordance with the terms of the underlying debt security, the related credit default options would be replaced by one or more credit default options derived from the debt securities of the successor entity or entities. To the extent necessary and appropriate for the protection of investors and the public interest, all other terms and conditions of the successor options would be the same as the original credit default options. 25 *See* CBOE Proposed Rule 29.4. Second, if the specific debt security (the Reference Obligation) is redeemed during the life of the credit default option, another debt security of the Reference Entity would be specified as the new Reference Obligation. In the event that all debt securities of the Reference Entity ( *i.e.* , all Relevant Obligations) are redeemed during the life of the credit default option, the option would cease trading and, assuming that CBOE has not confirmed a credit event, the contract payout would be $0. F. Position Limits Pursuant to proposed CBOE Rule 29.5, credit default options will be subject to a position limit equal to 5,000 contracts on the same side of the market. Credit default options shall not be aggregated with option contracts on the same underlying security and will not be subject to the hedge exemption to CBOE's standard position limits. Instead, the following hedge exemption strategies and positions shall be exempt from CBOE's position limits:
(i)A credit default option position “hedged” or “covered” by an appropriate amount of cash to meet the cash settlement amount obligation ( *e.g.* , $100,000 for a credit default option with an exercise settlement value of $100 multiplied by a contract multiplier of 1,000); and
(ii)a credit default option position “hedged” or “covered” by an amount of an underlying debt security(ies) that serves as a Relevant Obligation(s) or other securities, instruments, or interests related to the Reference Entity that is sufficient to meet the cash settlement amount obligation. 26 Also, CBOE's market-maker and firm facilitation exemptions to position limits will apply. 27 26 *See* proposed CBOE Rule 29.5. 27 Proposed CBOE Rule 29.5 requires that for purposes of its market-maker hedge exemption (CBOE Rule 4.11.05) the position must be within 20% of the applicable limit before an exemption would be granted. With respect to CBOE's firm facilitation exemption (CBOE Rule 4.11.06), proposed CBOE Rule 29.5 provides that the aggregate exemption position could not exceed three times the standard limit of 5,000 contracts. G. Margin The margin (both initial and maintenance) required for writing short and long positions in credit default options will be as follows: 28 28 *See* proposed CBOE Rule 12.3( *l* ); Amendment No. 5. • For a qualified customer 29 carrying a long position in credit default options, the margin requirement will be 20% of the current market value of the credit default option. 29 Proposed CBOE Rule 12.3( *l* )(1)(i) defines “qualified customer” as a person or entity that owns and invests on a discretionary basis no less than $5,000,000 in investments. • For a non-qualified customer carrying a long position in a credit default option, the margin requirement will be 100% of the current market value of the credit default option. • For a non-qualified customer carrying a short position in a credit default option, the margin requirement will be the cash settlement amount, *i.e.* , $100,000 per contract. • For a qualified customer carrying a short position in a credit default option, the margin requirement will be the lesser of the current market value plus 20% of the cash settlement amount or the cash settlement amount. These requirements may be satisfied by a deposit of cash or marginable securities. These requirements may not be satisfied by presentation to the member organization carrying the customer's account of a letter of credit meeting the requirements of proposed CBOE Rule 12.3( *l* )(1)(iii). 30 30 In Amendment No. 5, CBOE deletes from proposed rule 12.3( *l* )(1)(iii) the option of using a letter of credit to satisfy margin requirements applicable to credit default options and makes non-substantive corrections to the formatting of proposed CBOE Rule 12.3( *l* )(1)(iii) and the “Interpretations and Policies” heading that accompanies CBOE Rule 12.3. A credit default option carried short in a customer's account will be deemed a covered position, and eligible for the cash account, provided any one of the following is either held in the account at the time the option is written or is received into the account promptly thereafter:
(i)Cash or cash equivalents equal to 100% of the cash settlement amount or
(ii)an escrow agreement. The Exchange believes that these requirements strike the appropriate balance and adequately address concerns that a member or its customer may try to maintain an inordinately large unhedged position in credit default options. In addition, in Amendment No. 5, the Exchange notes that, in accordance with CBOE Rule 12.3(a)(3), an escrow agreement must be issued in a form acceptable to the Exchange, and that it has traditionally recognized as acceptable the escrow agreement forms of the OCC and the New York Stock Exchange. In Amendment No. 5, the Exchange also represents the following: “As part of its regulatory oversight of member organizations, the Exchange generally reviews member organizations' compliance with margin requirements applicable to customer accounts. In the future, the Exchange will include [c]redit [d]efault [o]ption margin requirements as part of this review. Additionally, the Exchange will review member organizations' internal procedures for managing credit risk associated with extending margin to customers trading [c]redit [d]efault [o]ptions. The Exchange also notes that, pursuant to CBOE Rule 12.10, the Exchange may at any time impose higher margin requirements when it deems such higher margin requirements advisable.” Lastly, in Amendment No. 5, the Exchange makes non-substantive changes to the text of CBOE Rule 12.5, to clarify that a credit default option that is carried for the account of a qualified investor may be deemed to have market value for the purposes of CBOE Rule 12.3(c). H. Surveillance The Exchange has represented that it will have in place adequate surveillance procedures to monitor trading in credit default options prior to listing and trading such options. III. Solicitation of Comments Interested persons are invited to submit written data, views, and arguments concerning Amendment No. 5, including whether Amendment No. 5 is consistent with the Act. Comments may be submitted by any of the following methods: Electronic Comments • Use the Commission's Internet comment form ( *http://www.sec.gov/rules/sro.shtml* ); or • Send an e-mail to *rule-comments@sec.gov* . Please include File Number SR-CBOE-2006-84 on the subject line. Paper Comments • Send paper comments in triplicate to Nancy M. Morris, Secretary, Securities and Exchange Commission, Station Place, 100 F Street, NE., Washington, DC 20549-1090. All submissions should refer to Amendment No. 5 to File Number SR-CBOE-2006-84. This file number should be included on the subject line if e-mail is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site ( *http://www.sec.gov/rules/sro.shtml* ). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room. Copies of such filing also will be available for inspection and copying at the principal office of the Exchange. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to Amendment No. 5 of File Number SR-CBOE-2006-84 and should be submitted on or before July 3, 2007. IV. Discussion The Commission finds that the proposed rule change is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities exchange. 31 In particular, the Commission finds that the proposal is consistent with Section 6(b)(5) of the Act, 32 which requires, among other things, that the rules of an exchange be designed to prevent fraudulent and manipulative acts and practices; to promote just and equitable principles of trade; to foster cooperation and coordination with persons engaged in regulating, clearing, processing information with respect to, and facilitating transactions in securities; to remove impediments to and perfect the mechanism of a free and open market and a national market system; and, in general to protect investors and the public interest. The CBOE's proposal, by enabling CBOE to offer a security that will be listed and traded on the Exchange, as opposed to the OTC market, would extend to investors the benefits of a listed exchange market, which include: A centralized market center; an auction market with posted, transparent market quotations and transaction reporting; standardized contract specifications; and the guarantee of the OCC. 31 In approving this proposed rule change, the Commission notes that it has considered the proposed rule's impact on efficiency, competition, and capital formation. *See* 15 U.S.C. 78c(f). 32 15 U.S.C. 78f(b)(5). As a threshold matter, the Commission finds that the credit default options proposed by CBOE are securities. Section 3(a)(10) of the Act 33 defines security to include, in part, “any put, call, straddle, option or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof).” After careful analysis, the Commission finds that credit default options are options 34 based on the value of a security or securities and, therefore, securities under Section 3(a)(10) of the Act; 35 in addition, the Commission finds that credit default options are options on an interest in, or based on the value of an interest in, a security or securities and, therefore, are securities under Section 3(a)(10) of the Act. 36 33 15 U.S.C. 78c(a)(10). 34 Although credit default options do not share every feature of a classic option, the Commission nonetheless finds that credit default options are option contracts. In particular, the Commission notes that the buyer of a credit default option pays to the seller a nonrefundable premium, has rights but no further obligations under the contract, and has no further risk exposure because the seller bears all the risk of the credit event occurring. *See United States* v. *Bein* , 728 F.2d 107, 112 (2d Cir. 1984) (highlighting characteristics that distinguish options from futures contracts). 35 15 U.S.C. 78c(a)(10). 36 15 U.S.C. 78c(a)(10). In determining whether a derivative is a security, the Commission and the courts have looked to the economic reality of the product. *See Caiola* v. *Citibank, N.A., New York, 295 F.3d 312, 325 (2d Cir. 2002)* , *quoting United Housing Foundation* v. *Foreman* , 421 U.S. 837, 848
(1975)(“In searching for the meaning and scope of the word ‘security’ * * * the emphasis should be on economic reality”). Construing the definition of a security in this manner permits the Commission and the courts “sufficient flexibility to ensure that those who market investments are not able to escape the coverage of the Securities Acts by creating new instruments that would not be covered by a more determinate definition.” *Reves* v. *Ernst & Young* , 494 U.S. 56, 63 n.2 (1990). The Commission interprets “based on the value [of a security or securities]” in Section 3(a)(10) of the Act 37 to include options whose pricing in the secondary market moves in relation to the value of the underlying security or securities of the option in question. Thus the fact that the payout of a cash-settled option will not increase or decrease based on the price movement of the underlying security of that option is not dispositive. 38 37 *Id* . 38 In addressing whether a “digital option” or a “binary option” with a fixed payout is an option based on the value of a security or securities, the court in *Stechler* v. *Sidley, Austin Brown & Wood, L.L.P.* , 382 F.Supp.2d 580, 596-97 (S.D.N.Y. 2005), held that the issue ultimately turned on questions of fact and declined to decide the issue on a motion to dismiss. However, the court's analysis made clear that the existence of a fixed payout that is not tied in a proportionate manner to the price of an underlying security is not a determining factor in deciding whether an instrument is an option on a security. Rather, the court accepted that, in evaluating the economic reality of an instrument, it is appropriate to consider whether the resale value of the instrument moves in relation to the movement of an underlying reference. Because credit default options are not currently traded, there is no empirical data regarding their pricing in the secondary market. However, credit default options are essentially exchange-traded equivalents of single-name, OTC credit default swaps. 39 A single-name credit default swap is an agreement between a protection buyer and a protection seller whereby the buyer pays a periodic fee in return for a contingent payment by the seller upon the occurrence of a credit event with respect to one or more reference obligations of a reference entity. Credit events typically include one or more of the following:
(1)Bankruptcy,
(2)obligation acceleration,
(3)obligation default,
(4)a failure to pay,
(5)repudiation or moratorium, or
(6)restructuring. Similarly, as explained above, each credit default option shall specify
(a)the Reference Entity,
(b)the specific debt security or securities that serve as its Reference Obligation or other Relevant Obligations, and
(c)the applicable events of default that trigger payout (as determined in accordance with the terms of the Reference Obligation or other Relevant Obligations), which could include such events as a failure to pay, obligation acceleration or default, and restructuring. Hence, credit default options have essentially the same structure as credit default swaps. 39 Despite the similarities between credit default options and OTC credit default swaps, the Commission wishes to make two things clear. First, because credit default options will be exchange-traded and not individually negotiated (and not necessarily between eligible contract participants), they are not qualifying swap agreements under Section 206A of the Gramm-Leach-Bliley Act (“GLBA”), 15 U.S.C. 78c note, and, therefore, not excluded from the definition of security by Section 3A of the Act, 15 U.S.C. 78c-1. Second, certain OTC credit default swaps are not securities. The finding that credit default options are securities because they are options based on the value of a security might suggest that OTC credit default swaps are also options based on the value of a security or securities and, therefore, excluded from the definition of swap agreement because Section 206A(b)(1) of the GLBA, 15 U.S.C. 78c note, excludes from the definition of swap agreement “any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities, including any interest therein or based on the value thereof.” However, Congress specifically enumerated “credit default swaps” (without defining the term) as one example of a qualifying swap agreement. *See* Section 206A(a)(3) of the GLBA, 15 U.S.C. 78c note. The Commission views the specific enumeration of “credit default swaps” as reflecting the intention of Congress to exclude certain OTC credit default swaps from the definition of security pursuant to Sections 206B & C of the GLBA, 15 U.S.C. 78c note. Credit default swaps that involve terms similar to credit default options, but that are otherwise excluded from the definition of security because they are qualifying swap agreements, remain subject to the Commission's antifraud jurisdiction (including authority over insider trading) as “security-based swap agreements” under Section 206B of the GLBA, 15 U.S.C. 78c note. In the case of a credit default swap, the amount the buyer pays for protection is based on a quoted spread expressed in basis points on a notional amount specified in the swap agreement. This quoted spread is often referred to as a “CDS spread” and is principally based on the probability that the Reference Entity will default ( *i.e.* , its creditworthiness). More specifically, the CDS spread represents the price required by a swap counterparty to compensate it for the credit risk associated with the potential default on a particular reference obligation or obligations of an issuer. Similarly, the value of a debt security is a function of the issuer's creditworthiness, which is expressed in terms of a “yield spread” (sometimes called “credit spread”). The yield (or credit) spread is the difference between the yield on the debt instrument and the yield on a debt security of similar maturity whose yield represents pure interest rate risk, such as U.S. Treasuries, 40 and represents the additional yield required by an investor to compensate it for the credit risk associated with the potential default on the particular debt instrument of an issuer. 41 As a consequence of this relationship between debt securities and credit default swaps, the credit default swap market enables more widespread trading in an issuer's creditworthiness than was previously possible. 40 Some academics have hypothesized that there may be some deviation between the yield on U.S. Treasuries and pure interest rate risk because bond interest is subject to state tax but U.S. Treasuries are not. *See* , *e.g.* , Haibin Zhu, *An Empirical Comparison of Credit Spreads between the Bond Market and the Credit Default Swap Market* , BIS Working Papers No. 160 (August 2004) (also noting that transparency and the widespread use of U.S. Treasuries as collateral could explain apparent deviations). 41 While the terms of both corporate securities and credit default swaps are established when parties enter into the respective contracts, the fair market value of these contracts can vary over the life of the contracts in response to changing perceptions of the creditworthiness of an issuer. There is a close empirical correlation between the price of a credit default swap (as expressed in the CDS spread) and the yield (or credit) spread of the specific reference obligation or obligations of that credit default swap. 42 This correlation is to be expected because the valuation of credit default swaps and debt securities are each based on credit risk, and because of the potential for arbitrage between the secondary bond market and the credit default swap market. 43 Similarly, because credit default options are exchange-traded equivalents of credit default swaps, the Commission expects that there will be a close empirical correlation between the pricing of a specific credit default option during the life of the contract and the yield spread of the Reference Obligation or other Relevant Obligations of that credit default option. 42 *See* , *e.g.* , Roberto Blanco, Simon Brennan, and Ian W. Marsh, *An Empirical Analysis of the Dynamic Relation between Investment-Grade Bonds and Credit Default Swaps* , The Journal of Economics, Volume LX, No. 5 (Oct. 2005) (finding credit default swap spreads to be quite close to bond yield spreads). 43 *See* Zhu, *An Empirical Comparison of Credit Spreads between the Bond Market and the Credit Default Swap Market* , *supra* note 40. We further note, more generally, that credit default options expressly reference in their payout conditions a term of an underlying security that is material to the value of that security. A credit default option will pay out if there is a failure to pay or other default event under the terms of the underlying debt security. For these reasons, credit default options are options “based on the value [of a security or securities]” and, therefore, securities. In addition, the Commission has determined that credit default options are options on an “interest in,” or based on the value of an interest in, a security or securities within the meaning of Section 3(a)(10) of the Act. 44 A security is a collection of rights (and obligations) running between the issuer and the holder of the security. The concept of an “interest in” a security plainly includes rights generating a pecuniary interest in a security, such as the right to a dividend payment or bond (coupon) payment. One relevant “interest in” a debt security underlying a credit default option is the right to receive (coupon) payments under the terms of that debt security. When a (coupon) payment is not made, impairing the value of that interest, the protection seller must make a payment to the protection buyer. Similarly, a specified default event may trigger other rights of a holder of the debt security. The default events that trigger exercise and payment under the credit default option are meaningful only because they are material terms of a security, essential to the debt holder's rights and interests in that security. 45 The credit default option payout is contingent on these security-dependent events. For these reasons, credit default options are options on an interest in, or based on the value of an interest in, a security or securities. 46 44 15 U.S.C. 78c(a)(10). 45 Although certain default events trigger the exercise and payment of a credit default option, it would not be accurate to describe these options as options on “an event”. There is no event delivered upon exercise of the option, rather a payment is delivered. The crucial question is what causes the option to be in-the-money and pay out. In the case of credit default options, it is an event that is created by a security. 46 It is important to note that merely because the option does not transfer ownership of the interest or right in a security—but instead becomes in-the-money and provides a cash payment if certain security rights are triggered—does not mean the option is not on an interest in a security. *Cf. Caiola* , 295 F.3d 312 (2d Cir. 2002) (including within the definition of “security” an option that did not deliver an actual security or interest in a security, but merely a cash payment). Moreover, the economic reality of credit default options supports the conclusion that credit default options are securities. Taking a short position ( *i.e.* , taking on the role of a protection seller) via credit default options would be akin to purchasing the corporate bond that is the Reference Obligation or other Relevant Obligations of that credit default option with the interest rate risk fully hedged. Both give the investor the same risk exposure to creditworthiness of an issuer. Indeed, credit default options may even more closely reflect the financial condition of an SEC-registered issuer because, unlike corporate bonds, which reflect both an issuer's creditworthiness and general interest rate risk, credit default options would only reflect an issuer's creditworthiness. That ability to isolate and transfer credit risk, backed by the guarantee of a central counterparty and the transparency of an exchange, should provide investors with additional opportunities to gain exposure to the public debt market. For these reasons, the Commission finds that credit default options are options based on the value of, and options on interests in or based on the value of interests in, a security or securities of the Reference Entity and, therefore, securities under Section 3(a)(10) of the Act. 47 47 15 U.S.C. 78c(a)(10). Further, the Commission believes that the listing rules proposed by CBOE for credit default options are reasonable and consistent with the Act. The Commission notes in particular that a credit default option must be based on a Reference Obligation issued by an entity that issues registered equity securities that are NMS stocks and that meet the Exchange's standards for listing an equity option. These requirements are reasonably designed to facilitate investors' access to information about the Reference Entity that may be necessary to price a credit default option appropriately. The Commission believes that the proposed position limits and margin rules for credit default options are reasonable and consistent with the Act. The proposed position limit of 5,000 contracts in any credit default option class appears to reasonably balance the promotion of a free and open market for these securities with minimization of incentives for market manipulation and insider trading. The proposed margin rules appear reasonably designed to deter a member or its customer from assuming an imprudent position in credit default options. In support of this proposal, the Exchange made the following representations: • The Exchange will have in place adequate surveillance procedures to monitor trading in credit default options prior to listing and trading such options, thereby helping to ensure the maintenance of a fair and orderly market for trading in credit default options. • The Exchange and the OPRA will have the necessary systems capacity to accommodate the additional volume associated with credit default options as proposed. This approval order is conditioned on CBOE's adherence to these representations. For the foregoing reasons, the Commission finds that the proposed rule is consistent with the Act. V. Accelerated Approval The Commission finds good cause for approving the proposed rule change, as modified by Amendment No. 5, prior to the thirtieth day after publishing notice of Amendment No. 5 in the **Federal Register** pursuant to Section 19(b)(2) of the Act. 48 In Amendment No. 5, CBOE:
(1)Modified the text of the proposed margin requirements applicable to credit default options contained in proposed Rules 12.3 and 12.5;
(2)made corresponding changes to the discussion sections of the Form 19b-4 and the Exhibit 1 thereto; and
(3)inserted information in the discussion sections of the Form 19b-4 and the Exhibit 1 thereto regarding the form of escrow agreements and the Exchange's supervision of member organizations that extend margin to customers trading Credit Default Options. 49 The Commission believes that Amendment No. 5 raises no significant regulatory issues. The Commission therefore finds good cause exists to accelerate approval of the proposed change, as modified by Amendment No. 5, pursuant to Section 19(b)(2) of the Act. 48 15 U.S.C. 78s(b)(2). Pursuant to Section 19(b)(2) of the Act, the Commission may not approve any proposed rule change, or amendment thereto, prior to the thirtieth day after the date of publication of the notice thereof, unless the Commission finds good cause for so doing. 49 The changes pursuant to Amendment No. 5 are discussed more fully in Section II.G, supra. VI. Designation of Credit Default Options Pursuant to Rule 9b-1 Rule 9b-1 establishes a disclosure framework for standardized options that are traded on a national securities exchange and cleared through a registered clearing agency. Under this framework, the exchange on which a standardized option is listed and traded must prepare an Options Disclosure Document (“ODD”) that, among other things, identifies the issuer and describes the uses, mechanics, and risks of options trading, in language that can be easily understood by the general investing public. The ODD is treated as a substitute for the traditional prospectus. A broker-dealer must provide a copy of the ODD to each customer at or before approving of the customer's account for trading any standardized option. 50 Any amendment to the ODD must be distributed to each customer whose account is approved for trading the options class for which the ODD relates. 51 50 *See* 17 CFR 240.9b-1(d)(1). 51 *See* 17 CFR 240.9b-1(d)(2). Under Rule 9b-1, use of the ODD is limited to “standardized options” for which there is an effective registration statement on Form S-20 under the Securities Act or that are exempt from registration. 52 The Commission specifically reserved in Rule 9b-1 the ability to designate as standardized options other securities “that the Commission believes should be included within the options disclosure framework.” 53 52 *See* 17 CFR 240.9b-1(b)(1) and (c)(8). *See also* 17 CFR 230.238. Rule 238 under the Securities Act provides an exemption from the Securities Act for any standardized option, as defined by Rule 9b-1(a)(4) under the Act, with limited exceptions. Rule 238 does not exempt standardized options from the antifraud provisions of Section 17 of the Securities Act, 15 U.S.C. 77q. Also, offers and sales of standardized options by or on behalf of the issuer of the underlying security or securities, an affiliate of the issuer, or an underwriter, will constitute an offer or sale of the underlying security or securities as defined in Section 2(a)(3) of the Securities Act, 15 U.S.C. 77b(a)(3). *See also* Securities Act Release No. 8171 (December 23, 2002), 68 FR 188 (January 2, 2003) (Exemption for Standardized Options From Provisions of the Securities Act of 1933 and From Registration Requirements of the Exchange Act of 1934). 53 *See* Securities Exchange Act Release No. 19055 and Securities Act Release No. 6426 (September 16, 1982), 47 FR 41950, 41954 (September 23, 1982). The Commission hereby designates credit default options, as defined in the OCC Proposal, 54 as standardized options for purposes of Rule 9b-1 under the Act. Credit default options do not meet the definition of “standardized options,” because they do not have an exercise price. However, they resemble standardized options in other significant respects. Credit default options have an underlying security and an expiration date. Like other standardized options, credit default options have standardized terms relating to exercise procedures, contract adjustments, time of issuance, effect of closing transactions, restrictions, and other matters pertaining to the rights and obligations of holders and writers. Further, credit default options are designed to provide market participants with the ability to hedge their exposure to an underlying security. The fact that credit default options lack a specified exercise price does not detract from this option-like benefit. The Commission believes that the fact that the OCC, the clearing agency for all standardized options, is willing to serve as issuer of credit default options supports the view that adding credit default options to the standardized option disclosure framework is reasonable. 54 For purposes of its proposal, OCC would define the term “credit default option” as an option that is automatically exercised upon receipt by the OCC of a credit event confirmation with respect to the reference obligation(s) of a reference entity. Credit default options have only two possible payoff outcomes: Either a fixed automatic exercise settlement amount or nothing at all. *See* proposed Section 1.C.(2) of Article XIV of the OCC By-Laws. • I11“Credit event” would be as defined in the rules of the exchange on which the credit default options are listed, with respect to a reference obligation for such option. *See* proposed Section 1.C.(3) of Article XIV of the OCC By-Laws. • I11“Reference entity” would mean the issuer or guarantor of the reference obligation(s). *See* proposed Section 1.R.(1) of Article XIV of the OCC By-Laws. • I11“Reference obligations” would mean one or more debt securities the terms of which define a credit event for a class of credit default options, as provided in the rules of the listing exchange. *See id.* Therefore, the Commission hereby designates credit default options, such as those proposed by CBOE, as standardized options for purposes of Rule 9b-1 under the Act. VII. Conclusion *It is therefore ordered* , pursuant to Section 19(b)(2) of the Act, 55 that the proposed rule change (SR-CBOE-2006-84) as modified by Amendment Nos. 3, 4, and 5, be, and hereby is approved on an accelerated basis. 55 15 U.S.C. 78s(b)(2). *It is further ordered* , pursuant to Rule 9b-1(a)(4) under the Act, the credit default options, as defined in proposed rule change (SR-OCC-2007-01) are designated as standardized options. By the Commission. Florence E. Harmon, Deputy Secretary. [FR Doc. E7-11273 Filed 6-11-07; 8:45 am] BILLING CODE 8010-01-P SECURITIES AND EXCHANGE COMMISSION [Release No. 34-55864; File No. SR-ISE-2007-35] Self-Regulatory Organizations; International Securities Exchange, LLC; Notice of Filing and Order Granting Accelerated Approval of a Proposed Rule Change to Permanently Extend the Pilot Program for Preferenced Orders June 5, 2007. Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”), 1 and Rule 19b-4 thereunder, 2 notice is hereby given that on May 9, 2007, the International Securities Exchange, LLC (“ISE” or “Exchange”) filed with the Securities and Exchange Commission (“Commission”) the proposed rule change as described in Items I and II below, which Items have been prepared by the Exchange. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons and is approving the proposal on an accelerated basis. 1 15 U.S.C. 78s(b)(1). 2 17 CFR 240.19b-4. I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change The ISE is proposing to make permanent its pilot program for Preferenced Orders. The text of the proposed rule change is available on ISE's Web site at *http://www.ise.com,* at the Exchange's principal office, and at the Commission's Public Reference Room. II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change In its filing with the Commission, the Exchange included statements concerning the purpose of and basis for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item III below. The Exchange has prepared summaries, set forth in Sections A, B, and C below, of the most significant aspects of such statements. A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change 1. Purpose The purpose of the proposed rule change is to make permanent the Exchange's pilot program for preferenced orders as provided in paragraph .03 of the Supplementary Material to Rule 713. The proposal amends ISE's procedure for allocating trades among market makers and non-customer orders under Rule 713 to provide an enhanced allocation to a “Preferred Market Maker” when it is quoting at the national best bid or offer (“NBBO”). Specifically, an Electronic Access Member may designate any market maker appointed to an options class to be a Preferred Market Maker on orders it enters into the Exchange's system (“Preferenced Orders”). If the Preferred Market Maker is not quoting at the NBBO at the time the Preferenced Order is received, the Exchange's existing allocation and execution procedures will be applied to the execution. 3 The proposed rule is subject to a pilot program that is currently set to expire on June 10, 2007. 4 3 Marketable customer orders are not automatically executed at prices inferior to the NBBO. If the ISE best bid or offer is inferior to the NBBO, it is handled by the Primary Market Maker according to Rule 803(c). 4 *See* Securities Exchange Act Release No. 53921 (June 1, 2006), 71 FR 33019 (June 7, 2006). Under the proposal, if a Preferred Market Maker is quoting at the NBBO at the time a Preferenced Order is received, the allocation procedure is modified so that the Preferred Market Maker will receive an enhanced allocation instead of the Primary Market Maker 5 equal to the greater of:
(i)The proportion of the total size at the best price represented by the size of its quote; or
(ii)sixty percent of the contracts to be allocated if there is only one other Non-Customer Order or market maker quotation at the best price and forty percent if there are two or more other Non-Customer Orders and/or market maker quotes at the best price. 6 Unexecuted contracts remaining after the Preferred Market Maker's allocation would be allocated pro-rata based on size as described above. 5 A Primary Market Maker may be the Preferenced Market Maker, in which case such market maker would receive the enhanced allocation for Preferenced Market Makers. 6 All allocations are automatically performed by the Exchange's system. Pursuant to this proposed rule change seeking permanent approval of the pilot program, the Exchange also proposes to delete from the Notes section in its Schedule of Fees a reference to the Preferenced Orders pilot program that was adopted when the Exchange initiated a payment for order flow program for Competitive Market Makers. 7 7 *See* Securities Exchange Act Release No. 53127 (January 13, 2006), 71 FR 3582 (January 23, 2006) (Notice of Filing and Immediate Effectiveness of Proposed Rule Change Relating to Payment for Order Flow Fee Changes). The Exchange believes the proposed rule change is a necessary competitive response to the preferencing rules adopted by other options exchanges and will help the ISE attract and retain order flow. This order flow will add depth and liquidity to the Exchange's markets and enable the Exchange to continue to compete effectively with other options exchanges. 2. Statutory Basis The basis under the Act for this proposed rule change is found in Section 6(b)(5), 8 in that the proposed rule change is designed to promote just and equitable principles of trade, remove impediments to and perfect the mechanisms of a free and open market and a national market system and, in general, to protect investors and the public interest. 8 15.U.S.C. 78f(b)(5). B. Self-Regulatory Organization's Statement on Burden on Competition The proposed rule change does not impose any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act. C. Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants or Others The Exchange has not solicited, and does not intend to solicit, comments on this proposed rule change. The Exchange has not received any unsolicited written comments from members or other interested parties. III. Solicitation of Comments Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule change is consistent with the Act. Comments may be submitted by any of the following methods: Electronic Comments • Use the Commission's Internet comment form ( *http://www.sec.gov/rules/sro.shtml* ); or • Send an e-mail to *rule-comments@sec.gov.* Please include File Number SR-ISE-2007-35 on the subject line. Paper Comments • Send paper comments in triplicate to Nancy M. Morris, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090. All submissions should refer to File Number SR-ISE-2007-35. This file number should be included on the subject line if e-mail is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site ( *http://www.sec.gov/rules/sro.shtml* ). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room. Copies of such filing also will be available for inspection and copying at the principal office of the Exchange. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Number SR-ISE-2007-35 and should be submitted on or before July 3, 2007. IV. Commission's Findings and Order Granting Accelerated Approval of the Proposed Rule Change After careful consideration, the Commission finds that the proposed rule change is consistent with the requirements of Section 6 of the Act 9 and the rules and regulations thereunder applicable to a national securities exchange, 10 and, in particular, the requirements of Section 6(b)(5) of the Act. 11 Section 6(b)(5) requires, among other things, that the rules of a national securities exchange be designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest. The Commission notes that the Exchange's program for Preferenced Orders was approved on a pilot basis approximately two years ago. 12 The Exchange has asked the Commission to approve the Exchange's program on a permanent basis. For the reasons noted by the Commission when it initially approved the Exchange's program for Preferenced Orders on a pilot basis, the Commission continues to believe that the Exchange's program does not jeopardize market integrity or the incentive for market participants to post competitive quotes. 13 Accordingly, the Commission finds that the proposal is consistent with the Act. 9 15 U.S.C. 78f. 10 In approving this proposal, the Commission has considered the proposed rule's impact on efficiency, competition, and capital formation. 15 U.S.C. 78c(f). 11 15.U.S.C. 78f(b)(5). 12 The Commission initially approved the Exchange's preferenced order program on a six week pilot basis while the Commission sought comment on the proposed rule change. *See* Securities Exchange Act Release No. 51818 (June 10, 2005), 70 FR 35146 (June 16, 2005). The Commission subsequently extended to the pilot period until June 10, 2006, which was one year from the date the Commission first approved the Exchange's Preferenced Order program on a pilot basis. *See* Securities Exchange Act Release No. 52066 (July 20, 2005), 70 FR 43479 (July 27, 2005). On June 1, 2006, the Commission further extended the pilot period until June 10, 2007. *See* Securities Exchange Act Release No. 53921 (June 1, 2006), 71 FR 33019 (June 7, 2006). 13 *See* Securities Exchange Act Release No. 51818 (June 10, 2005), 70 FR 35146 (June 16, 2005). The Exchange has requested that the Commission find good cause for approving the proposed rule change prior to the thirtieth day after publication of notice thereof in the **Federal Register** . The Commission believes that granting accelerated approval of the proposed rule change would allow the Exchange's program for Preferenced Orders to continue without disruption beyond the June 10, 2007 expiration date of the current pilot program. Accordingly, the Commission finds good cause, consistent with Section 19(b)(2) of the Act, 14 for approving the proposed rule change prior to the thirtieth day after publication of notice thereof in the **Federal Register** . 14 15 U.S.C. 78s(b)(2). V. Conclusion *It is therefore ordered,* pursuant to Section 19(b)(2) of the Act, 15 that the proposed rule change (SR-ISE-2007-35) is hereby approved on an accelerated basis. 15 15 U.S.C. 78s(b)(2). For the Commission, by the Division of Market Regulation, pursuant to delegated authority. 16 16 17 CFR 200.30-3(a)(12). Florence E. Harmon, Deputy Secretary. [FR Doc. E7-11268 Filed 6-11-07; 8:45 am] BILLING CODE 8010-01-P SECURITIES AND EXCHANGE COMMISSION [Release No. 34-55862; File No. SR-NASDAQ-2007-053] Self-Regulatory Organizations; The NASDAQ Stock Market LLC; Notice of Filing and Order Granting Accelerated Approval of Proposed Rule Change Relating to Trading Shares of the PowerShares DB Energy Fund, the PowerShares DB Oil Fund, the PowerShares DB Precious Metals Fund, the PowerShares DB Gold Fund, the PowerShares DB Silver Fund, the PowerShares DB Base Metals Fund, and the PowerShares DB Agriculture Fund Pursuant to Unlisted Trading Privileges June 5, 2007. Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”) 1 and Rule 19b-4 thereunder, 2 notice is hereby given that on May 16, 2007, The NASDAQ Stock Market LLC (“Nasdaq”), filed with the Securities and Exchange Commission (“Commission”) the proposed rule change as described in Items I and II below, which Items have been substantially prepared by Nasdaq. This order provides notice of the proposed rule change and approves the proposal on an accelerated basis. 1 15 U.S.C. 78s(b)(1). 2 17 CFR 240.19b-4. I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change Nasdaq proposes to trade, pursuant to unlisted trading privileges (“UTP”), shares (“Shares”) of the PowerShares DB Energy Fund, the PowerShares DB Oil Fund, the PowerShares DB Precious Metals Fund, the PowerShares DB Gold Fund, the PowerShares DB Silver Fund, the PowerShares DB Base Metals Fund, and the PowerShares DB Agriculture Fund (collectively the “Funds”). The text of the proposed rule change is available from Nasdaq's Web site at *http://nasdaq.complinet.com,* at Nasdaq's principal office, and at the Commission's Public Reference Room. II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change In its filing with the Commission, Nasdaq included statements concerning the purpose of, and basis for, the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item III below. Nasdaq has prepared summaries, set forth in Sections A, B, and C below, of the most significant aspects of such statements. A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change 1. Purpose Nasdaq is proposing to trade the Shares on a UTP basis. The Shares are currently trading on Nasdaq on a three-month pilot basis. 3 Approval of this filing will allow the Shares to continue to trade after the expiration of the pilot. The Commission previously approved a proposal to list and trade the Shares of the Funds by the American Stock Exchange LLC (the “Amex”). 4 3 Securities Exchange Act Release No. 55386 (March 2, 2007), 72 FR 10801 (March 9, 2007) (SR-NASDAQ-2007-016) (“Pilot Order”). 4 *See* Securities Exchange Act Release No. 55029 (December 29, 2006), 72 FR 806 (January 8, 2007) (SR-Amex-2006-76) (the “Amex Order”). The Shares represent beneficial ownership interests in the corresponding Fund's net assets, consisting solely of the common units of beneficial interests of the DB Energy Master Fund, the DB Oil Master Fund, the DB Precious Metals Master Fund, the DB Gold Master Fund, the DB Silver Master Fund, the DB Base Metals Master Fund, and the DB Agriculture Master Fund, respectively (collectively, the “Master Funds”). DB Multi-Sector Commodity Master Trust (the “Master Trust”) is organized as a Delaware statutory trust with each of the Master Funds representing a series of the Master Trust. The Master Funds will hold primarily 5 futures contracts 6 on the commodities comprising the Deutsche Bank Liquid Commodity Index—Optimum Yield Energy Excess Return TM , Deutsche Bank Liquid Commodity Index—Optimum Yield Crude Oil Excess Return TM , Deutsche Bank Liquid Commodity Index—Optimum Yield Precious Metals Excess Return TM , Deutsche Bank Liquid Commodity Index—Optimum Yield Gold Excess Return TM , Deutsche Bank Liquid Commodity Index—Optimum Yield Silver Excess Return TM , Deutsche Bank Liquid Commodity Index Optimum Yield Industrial Metals Excess Return TM , and Deutsche Bank Liquid Commodity Index—Optimum Yield Agriculture Excess Return TM (collectively, the “Indexes”), as the case may be. The sponsor of the Indexes is Deutsche Bank AG London (the “Index Sponsor”). Each of the Funds and each of the Master Funds are commodity pools operated by DB Commodity Services LLC (the “Managing Owner”). 7 5 Other holdings of the Master Fund will include cash and U.S. Treasury securities for deposit with futures commission merchants as margin, and other high-credit-quality short-term fixed income securities. 6 The following is a list of futures contracts and other commodity interests in which the respective Master Fund may invest and the exchanges on which they trade: Energy Index—sweet light crude (NYMEX), heating oil (NYMEX), brent crude oil (ICE Futures), RBOB gasoline (NYMEX), natural gas (NYMEX); Oil Index—sweet light crude (NYMEX); Precious Metals Index—gold (COMEX), silver (COMEX); Gold Index—gold (COMEX); Silver Index—silver (COMEX); Base Metals Index—aluminum (LME), zinc (LME), copper-grade A (LME); Agriculture Index—corn (CBOT), wheat (CBOT), soybeans (CBOT), sugar (NYBOT). 7 The Managing Owner is registered as a commodity pool operator (“CPO”) and commodity trading advisor (“CTA”) with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). The Managing Owner will serve as the CPO and CTA of each of the Funds and each of the Master Funds. Nasdaq deems the Shares to be equity securities, thus rendering trading in the Shares subject to the Nasdaq's existing rules governing the trading of equity securities, including Rule 4630. The Shares will trade on Nasdaq from 9:30 a.m. until 4:15 p.m. Eastern Time (“ET”), except that shares of the PowerShares DB Base Metals Fund will also trade from 4:15 p.m. until 8 p.m. ET, even if the Indicative Fund Value (“IFV”), as discussed below, is not disseminated from 4:15 p.m. until 8 p.m. ET. 8 Nasdaq has appropriate rules to facilitate transactions in the Shares during these trading sessions. 8 Because the LME is closed for floor and electronic trading during Nasdaq's after-hours trading session (from 4:15 p.m. until 8 p.m. ET), an updated IFV for the PowerShares DB Base Metals Fund cannot be calculated during such session. As provided by Rule 4120, Nasdaq may rely on the listing market to monitor dissemination of the IFV during Nasdaq's regular trading session (9:30 a.m. to 4:15 p.m. ET). Currently the Index Sponsor for the PowerShares DB Base Metals Fund's index does not calculate updated index values during Nasdaq's late trading session; however, if the Index Sponsor did so in the future, Nasdaq will not trade shares of the PowerShares DB Base Metals Fund unless such official index value is widely disseminated. Like other exchange-traded fund products, each of the Funds issues and redeems its Shares on a continuous basis at a price equal to the NAV per Share next determined after an order is received in proper form. Also, each of the Funds issues and redeem its Shares only in aggregations of 200,000 shares (“Basket Aggregations”) and only through qualified market participants that have entered into agreements with the Managing Owner (each, an “Authorized Participant”). Additional information about the creation and redemption process is included in the Amex Order. In summary, to create Shares, an Authorized Participant must properly place a creation order and deliver the specified “cash deposit amount” 9 and applicable transaction fee to The Bank of New York (the “Fund Administrator”). The Fund Administrator will issue to the Authorized Participant the appropriate number of Basket Aggregations. To redeem Shares, an Authorized Participant must properly place a redemption order and deliver Shares that in the aggregate constitute one or more Basket Aggregations, plus any applicable transaction fee. The Fund Administrator will deliver the appropriate “cash redemption amount” 10 for each Basket Aggregation that an Authorized Participant redeems. 9 The “cash deposit amount” equals the NAV per Share of the applicable Fund times 200,000 ( *i.e.* , NAV per Basket Aggregation). 10 The “cash redemption amount” equals the NAV per Basket Aggregation. On each business day, the Administrator makes available immediately prior to the opening of trading on Amex, through the facilities of the Consolidated Tape Association (“CTA”), the Basket Amount for the creation of a Basket. According to the Amex Order, Amex disseminates every 15 seconds throughout the trading day, via the facilities of the CTA, an amount representing on a per-Share basis, the current values of the Basket Amounts for each of the Funds. After 4 p.m. ET each business day, the Administrator determines the NAV for each of the Funds, utilizing the current settlement value of the particular commodity futures contracts. The calculation methodology for the NAV is described in more detail in the Amex Order. After 4 p.m. ET each business day, the Administrator, Amex, and the Managing Owner disseminate the NAVs for the Shares and the Basket Amounts (for orders placed during the day). The Basket Amounts and the NAVs are communicated by the Administrator to all Authorized Participants via facsimile or e-mail, and the NAV is available on the Funds' Web site at *http://www.dbfunds.db.com* . 11 11 The Funds also maintain information on a Web site at *http://www.powershares.com* . Nasdaq will provide a link from its Web site at *http://www.nasdaq.com* to the Funds' Web sites. Quotations for and last-sale information regarding the Shares are disseminated through the Consolidated Tape System (“CTS”). The Index Sponsor publishes the value of each of the Indexes at least once every 15 seconds throughout each trading day on the CTA, Bloomberg, Reuters, and on the Fund's Web site at *http://www.dbfunds.db.com* . The closing Index levels similarly are provided by the Index Sponsor. In addition, any adjustments or changes to the Indexes are provided by the Index Sponsor and Amex on their respective Web sites. The Web site for the Funds at *http://www.powershares.com* , which is publicly accessible at no charge, contains the following information:
(a)The current NAV per Share daily and the prior business day's NAV and the reported closing price;
(b)the mid-point of the bid-ask price in relation to the NAV as of the time the NAV is calculated (the “Bid-Ask Price”); 12
(c)the calculation of the premium or discount of such price against such NAV;
(d)data in chart form displaying the frequency distribution of discounts and premiums of the Bid-Ask Price against the NAV, within appropriate ranges for each of the four previous calendar quarters;
(e)the prospectus; and
(f)other applicable quantitative information. 12 The Bid-Ask Price of Shares is determined using the highest bid and lowest offer as of the time of calculation of the NAV. As described above, the respective NAVs for the Funds are calculated and disseminated daily to all market participants at the same time. According to the Amex Order, Amex also intends to disseminate for each of the Funds on a daily basis by means of CTA/CTS High Speed Lines information with respect to the corresponding IFV (as discussed below), recent NAV, and shares outstanding. Amex will also make available on its Web site daily trading volume of the Shares of each of the Funds, closing prices of such Shares, and the corresponding NAV. The closing price and settlement prices of the futures contracts comprising the Indexes and held by the corresponding Master Funds are also readily available from the relevant futures exchanges, automated quotation systems, published or other public sources, or on-line information services such as Bloomberg or Reuters. Amex has represented that it will disseminate through the facilities of the CTA an updated IFV for each of the Funds. The respective IFVs will be disseminated on a per-Share basis at least every 15 seconds from 9:30 a.m. to 4:15 p.m. ET, according to the Amex Order. The IFVs will be calculated based on the cash required for creations and redemptions for the respective Funds adjusted to reflect the price changes of the corresponding Index commodities through investments held by the Master Funds, *i.e.* , futures contracts. The IFVs will not reflect price changes to the price of an underlying commodity between the close of trading of the futures contract at the relevant futures exchange and 4:15 p.m. ET. While the Shares will trade on Nasdaq from 9:30 a.m. to 4:15 p.m. ET (and until 8 p.m. ET in the case of the shares of the PowerShares DB Base Metals Fund), regular trading hours for each of the Index commodities on the various futures exchanges vary widely, as set forth in detail in the Amex Order. Therefore, the value of a Share may be influenced by non-concurrent trading hours between the Nasdaq and the various futures exchanges on which the futures contracts based on the Index commodities are traded. Nasdaq will halt trading in the Shares under the conditions specified in Nasdaq Rules 4120 and 4121. The conditions for a halt include a regulatory halt by the listing market. UTP trading in the Shares will also be governed by provisions of Nasdaq Rule 4120 relating to temporary interruptions in the calculation or wide dissemination of the IFV or the value of the Index. Additionally, Nasdaq may cease trading the Shares if other unusual conditions or circumstances exist which, in the opinion of Nasdaq, make further dealings on Nasdaq detrimental to the maintenance of a fair and orderly market. Nasdaq will also follow any procedures with respect to trading halts as set forth in Nasdaq Rule 4120(c). Finally, Nasdaq will stop trading the Shares if the listing market delists them. Nasdaq believes that its surveillance procedures are adequate to address any concerns about the trading of the Shares on Nasdaq. Trading of the Shares through Nasdaq facilities is currently subject to NASD's surveillance procedures for equity securities in general and ETFs in particular. 13 Nasdaq is able to obtain information regarding trading in the Shares and the underlying futures contracts through its members in connection with the proprietary or customer trades that such members effect on any relevant market. In addition, Nasdaq may obtain trading information via the Intermarket Surveillance Group (“ISG”) from other exchanges who are members or affiliates of the ISG, including the CBOT and the NYBOT, and Nasdaq has Information Sharing Agreements in place with ICE, NYMEX, and LME. Nasdaq has issued an Information Circular to inform its members of the special characteristics and risks associated with trading the Shares. 13 NASD surveils trading pursuant to a regulatory services agreement. Nasdaq is responsible for NASD's performance under this regulatory services agreement. 2. Statutory Basis Nasdaq believes that the proposal is consistent with Section 6(b) of the Act 14 in general and Section 6(b)(5) of the Act 15 in particular, in that in that it is designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, remove impediments to a free and open market and a national market system, and, in general, to protect investors and the public interest. In addition, Nasdaq believes that the proposal is consistent with Rule 12f-5 under the Act 16 because it deems the Shares to be an equity securities, thus rendering trading in the Shares subject to Nasdaq's existing rules governing the trading of equity securities. 14 15 U.S.C. 78f(b). 15 15 U.S.C. 78f(b)(5). 16 17 CFR 240.12f-5. B. Self-Regulatory Organization's Statement on Burden on Competition Nasdaq does not believe that the proposed rule change will impose any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act. C. Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants or Others Written comments on the proposed rule change were neither solicited nor received. III. Solicitation of Comments Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule change is consistent with the Act. Comments may be submitted by any of the following methods: Electronic Comments • Use the Commission's Internet comment form ( *http://www.sec.gov/rules/sro.shtml* ); or • Send an e-mail to *rule-comments@sec.gov* . Please include File Number SR-NASDAQ-2007-053 on the subject line. Paper Comments • Send paper comments in triplicate to Nancy M. Morris, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090. All submissions should refer to File Number SR-NASDAQ-2007-053. This file number should be included on the subject line if e-mail is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site ( *http://www.sec.gov/rules/sro.shtml* ). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room. Copies of such filing also will be available for inspection and copying at the principal office of the Exchange. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Number SR-NASDAQ-2007-053 and should be submitted on or before July 3, 2007. IV. Commission's Findings and Order Granting Accelerated Approval of the Proposed Rule Change After careful review, the Commission finds that the proposed rule change is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities exchange. 17 In particular, the Commission finds that the proposed rule change is consistent with Section 6(b)(5) of the Act, 18 which requires that an exchange have rules designed, among other things, to promote just and equitable principles of trade, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and in general to protect investors and the public interest. The Commission believes that this proposal should benefit investors by increasing competition among markets that trade the Shares. 17 In approving this rule change, the Commission notes that it has considered the proposal's impact on efficiency, competition, and capital formation. *See* 15 U.S.C. 78c(f). 18 15 U.S.C. 78f(b)(5). In addition, the Commission finds that the proposal is consistent with Section 12(f) of the Act, 19 which permits an exchange to trade, pursuant to UTP, a security that is listed and registered on another exchange. 20 The Commission notes that it previously approved the listing and trading of the Shares on Amex. 21 The Commission also finds that the proposal is consistent with Rule 12f-5 under the Act, 22 which provides that an exchange shall not extend UTP to a security unless the exchange has in effect a rule or rules providing for transactions in the class or type of security to which the exchange extends UTP. The Exchange has represented that it meets this requirement because it deems the Shares to be equity securities, thus rendering trading in the Shares subject to the Exchange's existing rules governing the trading of equity securities. 19 15 U.S.C. 78 *l* (f). 20 Section 12(a) of the Act, 15 U.S.C. 78l(a), generally prohibits a broker-dealer from trading a security on a national securities exchange unless the security is registered on that exchange pursuant to Section 12 of the Act. Section 12(f) of the Act excludes from this restriction trading in any security to which an exchange “extends UTP.” When an exchange extends UTP to a security, it allows its members to trade the security as if it were listed and registered on the exchange even though it is not so listed and registered. 21 *See supra* note 4. 22 17 CFR 240.12f-5. The Commission further believes that the proposal is consistent with Section 11A(a)(1)(C)(iii) of the Act, 23 which sets forth Congress' finding that it is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure the availability to brokers, dealers, and investors of information with respect to quotations for and transactions in securities. Quotations for and last-sale information regarding the Shares are disseminated through the facilities of the CTA and the Consolidated Quotation System. Furthermore, the IFV of each Fund is disseminated every 15 seconds throughout the trading day by the national securities exchange on which the Fund is listed or by other information providers or market data vendors. 23 15 U.S.C. 78k-1(a)(1)(C)(iii). The Commission also believes that the Exchange's trading halt rules are reasonably designed to prevent trading in an ETF when transparency is impaired. Nasdaq will halt trading in the Shares under the conditions specified in Nasdaq Rules 4120 and 4121. The conditions for a halt include a regulatory halt by the listing market. UTP trading in the Shares will also be governed by provisions of Nasdaq Rule 4120 relating to temporary interruptions in the calculation or wide dissemination of the IFV or the value of the Index. Additionally, Nasdaq may cease trading the Shares if other unusual conditions or circumstances exist which, in the opinion of Nasdaq, make further dealings on Nasdaq detrimental to the maintenance of a fair and orderly market. Nasdaq will also follow any procedures with respect to trading halts as set forth in Nasdaq Rule 4120(c). The Commission notes that, if the Shares should be delisted by the listing exchange, the Exchange would no longer have authority to trade the Shares pursuant to this order. In support of this proposal, the Exchange has represented that its surveillance procedures are adequate to properly monitor Exchange trading of the Shares in all trading sessions and to deter and detect violations of Exchange rules. This approval order is conditioned on the Exchange's adherence to this representation. In addition, the Commission recently approved the trading of the Shares on the Exchange pursuant to UTP for a pilot period of three months. 24 In the Pilot Order, the Commission noted that exchanges that trade commodity-related securities generally have in place surveillance arrangements with markets that trade the underlying securities. In its proposal to trade the Shares for a pilot period, the Exchange represented that it was in the process of completing these surveillance arrangements and expected to do so “in the near future.” The Exchange recently provided the Commission with evidence that it has completed these surveillance arrangements. 24 *See supra* note 3. The Commission finds good cause for approving this proposal before the thirtieth day after the publication of notice thereof in the **Federal Register** . As noted previously, the Commission previously found that the listing and trading of the Shares on Amex is consistent with the Act. The Commission presently is not aware of any regulatory issue that should cause it to revisit that finding or would preclude the trading of the Shares on the Exchange pursuant to UTP. Therefore, accelerating approval of this proposal should benefit investors by creating, without undue delay, additional competition in the market for the Shares. V. Conclusion *It is therefore ordered* , pursuant to Section 19(b)(2) of the Act, 25 that the proposed rule change (SR-NASDAQ-2007-053) thereto, be and it hereby is, approved on an accelerated basis. 25 15 U.S.C. 78s(b)(2). For the Commission, by the Division of Market Regulation, pursuant to delegated authority. 26 26 17 CFR 200.30-3(a)(12). Florence E. Harmon, Deputy Secretary. [FR Doc. E7-11181 Filed 6-11-07; 8:45 am] BILLING CODE 8010-01-P SECURITIES AND EXCHANGE COMMISSION [Release No. 34-55856; File No. SR-NASDAQ-2007-029] Self-Regulatory Organizations; The NASDAQ Stock Market LLC; Order Approving a Proposed Rule Change, as Modified by Amendment No. 1, To Require Nasdaq-Listed Issuers To Submit Material News to Nasdaq Using Nasdaq's Electronic Disclosure Submission System June 4, 2007. I. Introduction On March 27, 2007, The NASDAQ Stock Market LLC (“Nasdaq”) filed with the Securities and Exchange Commission (“Commission”), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”), 1 and Rule 19b-4 thereunder, 2 a proposed rule change to require Nasdaq-listed issuers to submit material news to Nasdaq through Nasdaq's electronic disclosure submission system, except in emergency situations. Nasdaq filed Amendment No. 1 to the proposal on April 25, 2007. The proposed rule change, as amended, was published for comment in the **Federal Register** on May 2, 2007. 3 The Commission received no comments regarding the proposed rule change, as amended. This order approves the proposed rule change, as amended. 1 15 U.S.C. 78s(b)(1). 2 17 CFR 240.19b-4. 3 *See* Securities Exchange Act Release No. 55672 (April 26, 2007), 72 FR 24349. II. Description of the Proposal Nasdaq Rules 4310(c)(16) and 4320(e)(14) require a Nasdaq-listed issuer, except in unusual circumstances, to make prompt disclosure to the public through any Regulation FD compliant method (or combination of methods) of any material information that would reasonably be expected to affect the value of its securities or to influence investors' decisions. These rules also require the issuer to provide notice of certain disclosures to Nasdaq's MarketWatch Department (“Nasdaq MarketWatch”) prior to the release of the information. Nasdaq reviews these disclosures to determine whether a trading halt is appropriate. Issuers currently provide material news notifications to Nasdaq MarketWatch electronically through Nasdaq's electronic disclosure submission system, or via fax or telephone. Nasdaq does not disseminate this information. Although Nasdaq introduced the electronic disclosure submission system in 2004, most issuers continue to provide material news notifications to Nasdaq MarketWatch by fax. 4 According to Nasdaq, the material information from fax-delivered documents and telephone notifications must be retyped manually into Nasdaq MarketWatch's database systems, a process that uses staff time, introduces error risk, and results in a less robust audit trail. To reduce this administrative burden, Nasdaq proposes to amend Nasdaq Rule 4120, “Trading Halts,” and IM-4120-1, “Disclosure of Material Information,” to require issuers to submit material news notifications to Nasdaq through Nasdaq's electronic disclosure submission system, except in emergency situations. 5 In an emergency, an issuer would continue to be required to notify Nasdaq prior to disseminating material news, but Nasdaq would accept notification by telephone or fax. 4 Nasdaq notes, for example, that of approximately 4,200 material news notifications submitted to Nasdaq MarketWatch in January 2007, over 70% were submitted by fax. 5 Nasdaq defines emergency situations to include: lack of computer or internet access; a technical problem on either the issuer or Nasdaq system, or an incompatibility between those systems; and a material development such that no draft disclosure document exists, but immediate notification to Nasdaq MarketWatch is important based on the event. *See* Nasdaq IM-4120-1. Under the proposal, Nasdaq may issue a Staff Determination that is a public reprimand letter or, in extreme circumstances, a Staff Determination to delist an issuer's securities, if an issuer repeatedly fails to notify Nasdaq prior to the distribution of material news, or repeatedly fails to use the electronic disclosure submission system in the absence of an emergency. 6 In determining whether to issue a public reprimand letter, Nasdaq will consider whether the issuer has demonstrated a pattern of failures, whether the issuer has been contacted concerning previous violations, and whether the issuer has taken steps to assure that future violations will not occur. 7 6 *See* Nasdaq IM-4120-1. 7 *See* Nasdaq IM-4120-1. Nasdaq proposes to implement the proposal approximately 90 days after the proposal is approved. III. Discussion The Commission finds that the proposed rule change is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities exchange. 8 Specifically, the Commission finds that the proposal is consistent with Section 6(b)(5) of the Act, 9 which requires, among other things, that the rules of a national securities exchange be designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to remove impediments to and perfect the mechanism of a free and open market and a national market system and, in general, to protect investors and the public interest. 8 In approving this proposed rule change, the Commission has considered the proposed rule's impact on efficiency, competition, and capital formation. 15 U.S.C. 78c(f). 9 15 U.S.C. 78f(b)(5). By requiring issuers to submit material news notifications to Nasdaq through Nasdaq's electronic disclosure submission system, except in emergencies, the Commission believes that the proposal appears to be reasonably designed to reduce the administrative burdens and error risk associated with retyping material news information provided by telephone or fax into Nasdaq's database systems. By reducing the error risk associated with retyping this information into Nasdaq's database systems, the Commission also believes that the proposal appears to be reasonably designed to help to enhance the accuracy and integrity of Nasdaq's audit trail. Under the proposal, Nasdaq may issue a Staff Determination that is a public reprimand letter or, in extreme circumstances, a determination to delist an issuer's securities, if an issuer fails repeatedly to notify Nasdaq prior to the distribution of material news or fails repeatedly to use the electronic disclosure submission system in the absence of an emergency. 10 The Commission notes that the procedures in the Nasdaq Rule 4800 Series, “Procedures for Review of Nasdaq Listing Determinations,” will apply to any such Staff Determinations. 10 See Nasdaq IM-4120-1. *It is therefore ordered,* pursuant to Section 19(b)(2) of the Act, 11 that the proposed rule change (SR-NASDAQ-2007-029), as amended, is approved. 11 15 U.S.C. 78s(b)(2). For the Commission, by the Division of Market Regulation, pursuant to delegated authority. 12 12 17 CFR 200.30-3(a)(12). Florence E. Harmon, Deputy Secretary. [FR Doc. E7-11189 Filed 6-11-07; 8:45 am] BILLING CODE 8010-01-P SECURITIES AND EXCHANGE COMMISSION [Release No. 34-55854; File No. SR-NASDAQ-2006-045] Self-Regulatory Organizations; The NASDAQ Stock Market LLC; Notice of Filing of Proposed Rule Change and Amendment No. 1 Thereto To Allow the Use of a Company's Web Site To Distribute an Annual Report and Meet Other Nasdaq Listing Requirements June 4, 2007. Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”), 1 and Rule 19b-4 thereunder, 2 notice is hereby given that on October 31, 2006, The NASDAQ Stock Market LLC (“Nasdaq”) filed with the Securities and Exchange Commission (“Commission”) the proposed rule change as described in Items I, II, and III below, which Items have been substantially prepared by Nasdaq. On April 25, 2007, Nasdaq submitted Amendment No. 1, which replaced the text of the original filing in its entirety. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons. 1 15 U.S.C. 78s(b)(1). 2 17 CFR 240.19b-4. I. Self-Regulatory Organization's Statement of the Terms of the Substance of the Proposed Rule Change Nasdaq proposes changes to Rule 4350 to facilitate the use of technology to satisfy Nasdaq listing requirements and to make certain clarifying and technical corrections. Nasdaq will implement the proposed rule immediately upon approval. The text of the proposed rule change is below. Proposed new language is in *italic* ; proposed deletions are in brackets. 3 3 Changes are marked to the rule text that appears in the electronic manual of Nasdaq found at *http://www.complinet.com/nasdaq* . 4350. Qualitative Listing Requirements for Nasdaq Issuers Except for Limited Partnerships
(a)Applicability
(1)Foreign Private Issuers. A foreign private issuer may follow its home country practice in lieu of the requirements of Rule 4350, provided, however, that such an issuer shall: Comply with Rules 4350(b)(1)(B), 4350(j) and 4350(m), have an audit committee that satisfies Rule 4350(d)(3), and ensure that such audit committee's members meet the independence requirement in Rule 4350(d)(2)(A)(ii). A foreign private issuer that follows a home country practice in lieu of one or more provisions of Rule 4350 shall disclose in its annual reports filed with the Commission *or on its Web site* each requirement of Rule 4350 that it does not follow and describe the home country practice followed by the issuer in lieu of such requirements. In addition, a foreign private issuer making its initial public offering or first U.S. listing on Nasdaq shall make the same disclosures in its registration statement *or on its Web site.* (2)-(5) No change.
(b)Distribution of Annual and Interim Reports (1)(A) Each issuer *with common stock or voting preferred stock (or their equivalents) listed on Nasdaq* shall [distribute] *make available* to shareholders *of such securities* [copies of] an annual report containing audited financial statements of the company and its subsidiaries, *which may be on Form 10-K, 20-F, 40-F or N-CSR.* [The report shall be distributed to shareholders a reasonable period of time prior to the company's annual meeting of shareholders and shall be filed with Nasdaq at the time it is distributed to shareholders.] * An issuer may comply with this requirement either:
(i)By mailing the report to shareholders, or
(ii)by posting the annual report to shareholders on or through the company's Web site (or, in the case of an issuer that is an investment company that does not maintain its own Web site, on a Web site that the issuer is allowed to use to satisfy the Web site posting requirement in Exchange Act Rule 16a-3(k)), along with a prominent undertaking in the English language to provide shareholders, upon request, a hard copy of the company's annual report free of charge. An issuer that chooses to satisfy this requirement via a Web site posting must, simultaneous with this posting, issue a press release stating that its annual report has been filed with the Commission (or other appropriate regulatory authority). This press release must also state that the annual report is available on the company's Web site and include the Web site address and that shareholders may receive a hard copy free of charge upon request. An issuer must provide such hard copies within a reasonable period of time following the request. *
(B)An issuer that receives an audit opinion that [contains a going concern qualification] *expresses doubt about the ability of the company to continue as a going concern for a reasonable period of time* must make a public announcement through the news media disclosing the receipt of such [qualification] *opinion.* Prior to the release of the public announcement, the issuer must provide the text of the public announcement to the StockWatch section of Nasdaq's MarketWatch Department (“Nasdaq StockWatch”). The public announcement shall be provided to Nasdaq StockWatch and released to the media not later than seven calendar days following the filing of such audit opinion in a public filing with the Securities and Exchange Commission. (2)-(4) No change. (c)-(n) No change. IM 4350-6. Applicability 1. Foreign Private Issuer Exception and Disclosure. A foreign private issuer (as defined in Rule 3b-4 under the Act) listed on Nasdaq may follow the practice in such issuer's home country (as defined in General Instruction F of Form 20-F) in lieu of some of the provisions of Rule 4350, subject to several important exceptions. First, such an issuer shall comply with Rule 4350(b)(1)(B) (Disclosure of Going Concern Opinion), Rule 4350(j) (Listing Agreement) and Rule 4350(m) (Notification of Material Noncompliance). Second, such an issuer shall have an audit committee that satisfies Rule 4350(d)(3). Third, members of such audit committee shall meet the criteria for independence referenced in Rule 4350(d)(2)(A)(ii) (the criteria set forth in Rule 10A-3(b)(1), subject to the exemptions provided in Rule 10A-3(c) under the Act). Finally, a foreign private issuer that elects to follow home country practice in lieu of a requirement of Rule 4350 shall submit to Nasdaq a written statement from an independent counsel in such issuer's home country certifying that the issuer's practices are not prohibited by the home country's laws. In the case of new listings, this certification is required at the time of listing. For existing issuers, the certification is required at the time the company seeks to adopt its first non-compliant practice. In the interest of transparency, the rule requires a foreign private issuer to make appropriate disclosures in the issuer's annual filings with the Commission (typically Form 20-F or 40-F), and at the time of the issuer's original listing in the United States, if that listing is on Nasdaq, in its registration statement (typically Form F-1, 20-F, or 40-F); *alternatively, the issuer may provide these disclosures in English on its Web site.* The issuer shall disclose each requirement of Rule 4350 that it does not follow and include a brief statement of the home country practice the issuer follows in lieu of these corporate governance requirement(s). *If the disclosure is only available on the Web site, the annual report and registration statement should so state and provide the Web address at which the information may be obtained.* (2)-(4) No change. II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change In its filing with the Commission, Nasdaq included statements concerning the purpose of, and basis for, the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. Nasdaq has prepared summaries, set forth in Sections A, B, and C below, of the most significant aspects of such statements. A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change 1. Purpose Nasdaq proposes to make changes to its rules to facilitate the use of technology to satisfy Nasdaq listing requirements and to make certain clarifying and technical corrections. Annual Reports Pursuant to Nasdaq Rule 4350(b)(1)(A), each Nasdaq issuer is currently required to distribute to shareholders a copy of an annual report containing audited financial statements. 4 Nasdaq proposes to modify its rules to permit a company to distribute its annual report by posting it on a Web site and issuing a press release stating that the annual report has been filed with the Commission (or other appropriate regulatory authority), that such annual report is available on the company's publicly available Web site, and that shareholders can receive a hard-copy free of charge upon request. 5 Nasdaq believes that allowing companies to rely on the Internet to satisfy the requirement to provide shareholders with an annual report containing audited financial statements will allow companies to provide investors with information in a more timely, efficient and cost effective manner. At present, this proposal would only be meaningful to foreign private issuers because they are exempt from the Commission's proxy solicitation rules under Rule 3a12-3(b) of the Act. 6 However, the Commission recently approved rules that will permit issuers to rely on the Internet to deliver proxy materials, effective July 1, 2007, 7 and is considering further expanding those rules to require the use of the Internet to deliver proxy materials. 8 4 A foreign private issuer can follow its home country practice regarding distribution of annual reports instead of Nasdaq's rule, if it follows the procedures set forth in Rule 4350(a) regarding disclosure of this non-conforming practice. 5 This proposal is similar to a recent change by the New York Stock Exchange LLC to Section 203.01 of its Listed Company Manual. *See* Securities Exchange Act Release No. 54344 (August 21, 2006), 71 FR 51260 (August 29, 2006) (approving SR-NYSE-2005-68). 6 17 CFR 240.3a12-3(b). 7 *See* Securities Exchange Act Release No. 55146 (January 22, 2007), 72 FR 4148 (January 29, 2007). 8 *See* Securities Exchange Act Release No. 55147 (January 22, 2007), 72 FR 4176 (January 29, 2007). Nasdaq also proposes to specify that the annual report requirement is applicable only to issuers of common stock and voting preferred stock (and their equivalents) 9 and that the annual report requirement can be satisfied by providing the company's annual filing with the Commission, such as on Form 10-K, 20-F, 40-F, or N-CSR. Further, Nasdaq proposes to remove a provision related to the timing for delivery of the annual report, because the Commission's proxy rules already require that such information be provided before the annual meeting. 10 9 Common stock equivalents include, but are not limited to: Ordinary shares, shares or certificates of beneficial interest of Trust, American depositary receipts and American depositary shares. 10 Pursuant to Rule 14a-3(b), 17 CFR 240.14a-3(b), the proxy statement for a company's annual meeting must be accompanied or preceded by an annual report. State law requirements also govern the timing that notice of the meeting must be provided. *See, e.g.* , Section 222(b) of the Delaware General Corporation Law, which requires notice of a meeting not less than 10 nor more than 60 days prior to the meeting. In addition, Nasdaq proposes to make a technical correction to Rule 4350(b)(1)(B), relating to the disclosure required when the audit opinion of a company's annual financial statements contains a “going concern qualification.” 11 The proposed change removes the term “going concern qualification,” which is undefined in the accounting literature, and replaces it with language from Statement on Auditing Standard Number 59, which relates to the auditor's consideration of an entity's ability to continue as a going concern. Nasdaq believes that this clarification will remove confusion as to when the rule applies. 11 Conversation between Arnold Golub, Associate General Counsel, The Nasdaq Stock Market, Inc., Raymond Lombardo, Special Counsel, Division of Market Regulation (“Division”), Commission, and Molly Kim, Special Counsel, Division, Commission, on April 26, 2007. Disclosure of Non-Conforming Governance Practices Nasdaq requires that foreign private issuers disclose all non-conforming governance practices in their Form F-1, 20-F, or 40-F. 12 Nasdaq proposes to expand the existing Nasdaq rule to allow this disclosure to be made either in the Form F-1, 20-F, or 40-F, as applicable, or, in the alternative, the foreign private issuer may provide these disclosures in English on its Web site. If, however, the disclosure is only available on the foreign private issuer's Web site, the proposal requires that the issuer's annual report and registration statement should state this fact and provide the Web address at which the information may be obtained. 13 12 Nasdaq Rule 4350(a)(1) and IM-4350-6. 13 Conversation between Arnold Golub, Associate General Counsel, The Nasdaq Stock Market, Inc., Raymond Lombardo, Special Counsel, Division, Commission, and Molly Kim, Special Counsel, Division, Commission, on May 31, 2007. 2. Statutory Basis Nasdaq believes that the proposed rule change is consistent with the provisions of Section 6 of the Act, 14 in general, and with Section 6(b)(5) of the Act, 15 in particular. The proposed rule change would allow additional methods of disclosure for Nasdaq-listed companies, thereby reducing costs for those companies, and allowing them to rely on technology to provide information to investors in a timelier manner. As such, the proposed rule change is designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest. 14 15 U.S.C. 78f. 15 15 U.S.C. 78f(b)(5). B. Self-Regulatory Organization's Statement on Burden on Competition Nasdaq does not believe that the proposed rule change will result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act. C. Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants, or Others Written comments were neither solicited nor received. III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action Within 35 days of the date of publication of this notice in the **Federal Register** or within such longer period
(i)as the Commission may designate up to 90 days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding or
(ii)as to which the self-regulatory organization consents, the Commission will: A. By order approve such proposed rule change, or B. Institute proceedings to determine whether the proposed rule change should be disapproved. IV. Solicitation of Comments Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule change, as amended, is consistent with the Act. Comments may be submitted by any of the following methods: Electronic Comments • Use the Commission's Internet comment form ( *http://www.sec.gov/rules/sro.shtml* ); or • Send an e-mail to *rule-comments@sec.gov.* Please include File Number SR-NASDAQ-2006-045 on the subject line. Paper Comments • Send paper comments in triplicate to Nancy M. Morris, Secretary, Securities and Exchange Commission, Station Place, 100 F Street, NE., Washington, DC 20549-1090. All submissions should refer to File Number SR-NASDAQ-2006-045. This file number should be included on the subject line if e-mail is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site ( *http://www.sec.gov/rules/sro.shtml* ). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room. Copies of such filing also will be available for inspection and copying at the principal office of Nasdaq. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Number SR-NASDAQ-2006-045 and should be submitted on or before July 3, 2007. For the Commission, by the Division of Market Regulation, pursuant to delegated authority. 16 16 17 CFR 200.30-3(a)(12). Florence E. Harmon, Deputy Secretary. [FR Doc. E7-11267 Filed 6-11-07; 8:45 am] BILLING CODE 8010-01-P SECURITIES AND EXCHANGE COMMISSION [Release No. 34-55859; File No. SR-NYSE-2006-28] Self-Regulatory Organizations; New York Stock Exchange LLC; Notice of Filing of Amendment No. 4 to Proposed Rule Change and Order Granting Accelerated Approval of Proposed Rule Change as Modified by Amendment Nos. 2, 3, and 4 Relating to NYSE Rules 134 and 411 June 5, 2007. I. Introduction On May 2, 2006, the New York Stock Exchange LLC (“NYSE” or “Exchange”) filed with the Securities and Exchange Commission (“Commission”), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934, as amended (“Act”), 1 and Rule 19b-4 thereunder, 2 a proposed rule change to amend NYSE Rules 134 (Differences and Omissions-Cleared Transactions) and 411 (Erroneous Reports). On September 22, 2006, NYSE filed Amendment No. 1 to the proposed rule change. On February 20, 2007, NYSE filed Amendment No. 2 to the proposed rule change. The proposed rule change as modified by Amendment No. 2 was published for comment in the **Federal Register** on March 6, 2007. 3 The Commission received no comments on the proposal. On March 22, 2007, NYSE filed Amendment No. 3 to the proposed rule change. 4 On May 30, 2007, NYSE filed Amendment No. 4 to the proposed rule change. 5 This order approves the proposed rule change, as modified by Amendment Nos. 2, 3, and 4, on an accelerated basis. 1 15 U.S.C. 78s(b)(1). 2 17 CFR 240.19b-4. 3 *See* Securities Exchange Act Release No. 55361 (February 27, 2007), 72 FR 9985 (“Notice”). 4 In Amendment No. 3, the Exchange made technical changes to the rule text of the proposed rule change to correctly identify the numbering of NYSE Rule 134(g)(i) and
(ii)as proposed new text. These technical changes were reflected in the Notice. *See* footnote 5 of the Notice. This is a technical amendment and is not subject to notice and comment. 5 In Amendment No. 4, the Exchange made changes to the rule text of the proposed rule change to clarify the meaning of the term “system malfunction” contained in proposed NYSE Rule 134(h). The text of Amendment No. 4 is available on the Exchange's Web site ( *http://www.nyse.com* ), at the Exchange's Office of the Secretary, and at the Commission's Public Reference Room. II. Description A. Current Practice Currently, recognized trading errors fall into two categories. The first category applies to held 6 and not held 7 orders and includes trades that are mistakenly executed outside the written order instructions. These types of errors encompass situations where the transaction was incorrectly executed:
(i)In the wrong security;
(ii)on the wrong side of the market;
(iii)outside of the price instructions;
(iv)for a quantity greater than specified in the instructions; or
(v)duplicating a prior execution of the same original order. The second category of trading errors currently applies only to held orders and involves situations where a held order was executable in the prevailing market but the Floor broker failed to take advantage of the opportunity to execute the order at that time. 6 A “held” order is a market or limit order that the broker must execute as instructed without discretion as to the time of an execution. 7 A “not held” order is a market or limit order that gives the broker both time and price discretion to attempt to get the best possible execution. Under the current NYSE rules and interpretations, a Floor broker may use his or her error account to “assume or acquire” a position as a result of a recognized trading error so that the customer receives the trade he or she would have received had the recognized trading error not occurred. However, a Floor broker is not permitted to use his or error account in cases involving trading errors that are not recognized by the Exchange. Instead, in such cases, a Floor broker would generally issue a difference check 8 or offer a commission adjustment to resolve any monetary disadvantage suffered by the customer. 9 According to the Exchange, the issuance of the difference check or commission adjustment ultimately is not in the best interest of the customer because the administrative cost associated with the processing of the difference check or commission adjustment ultimately is borne by the customer and thus the remedy does not serve to make the customer whole. In addition, according to the Exchange, many institutional investors do not want the administrative burden of processing a difference check or commission adjustment as a result of the Floor broker's failure to execute a not held order due to administrative mistake or system malfunction. 8 A “difference check” is a check issued to the customer by the member to cover the monetary difference between the execution price and the price the customer and the member agree was the proper price. 9 If, at the time the Floor broker identifies the execution failure, the customer's order can be executed in the market at an equal or better price than the customer could have received had the order been executed in the prevailing market, then the Floor broker will execute the order. In the event the market is adverse to the customer's interest at the time the error is identified, under the current rules and interpretation, the remedy is to have the Floor broker issue a difference check or offer a commission reduction to address any disadvantage to the customer. *See* NYSE Regulation, Information Memorandum 02-19, issued April 17, 2002, clarifying the application of NYSE Rules 134, 411, and 407A. B. Proposed Amendments to NYSE Rule 134 (Differences and Omissions-Cleared Transactions The Exchange proposes to amend NYSE Rule 134 to codify the first category of recognized trading errors. Specifically, NYSE Rule 134(g) would define a trading error to include situations when an order is executed outside of a customer's instructions as entered in the electronic order tracking systems 10 of the Exchange. Types of recognized trading errors would include, but are not limited to, the execution of a held or not held order:
(i)In the incorrect security;
(ii)on the wrong side of the market;
(iii)at a price outside the price instructions;
(iv)for a quantity of shares greater than the amount of shares specified in the order instructions; or
(v)the execution of an order in duplicate. 11 In addition, Rule 134(g)(ii) would expand the type of recognized trading errors to include situations where a member fails to execute a not held order because he or she committed an error as to symbol, side or price in the execution of said order. 12 10 *See* NYSE Rule 123(e). 11 *See* proposed NYSE Rule 134(g)(i). 12 *See* proposed NYSE Rule 134(g)(ii). The Exchange also proposes to add Rule 134(h)(i) to codify the second category of recognized trading errors covering situations where the Floor broker failed to execute a held order that was executable in the prevailing market. 13 13 *See* proposed NYSE Rule 134(h)(i). The Exchange also proposes to add Rule 134(h)(ii) to the second category of recognized trading errors to cover those situations where a Floor broker failed to execute a not held order, in whole or in part, because the order was lost, misplaced or the order remains unexecuted as a result of a system malfunction. 14 In addition to previously sanctioned uses of a Floor broker's error account, a Floor broker would now be allowed utilize his or her error account, under NYSE Rule 134(j)(ii), to execute a customer's not held order in alignment with the Consolidated Tape, when the not held order remains unexecuted as a result of the order being lost or misplaced or as a result of a system malfunction. 15 To prevent abuse of the proposed new rules, the Exchange is also amending NYSE Rule 134(d)(iii) to require a Floor broker to keep contemporaneous records documenting the circumstances surrounding errors. A Floor broker would be required to make and keep a time stamped record 16 of the error including supporting documentation of the error. 17 In addition, the Member Firm Regulation Division of NYSE Regulation, Inc. would include a review of these records during the course of its routine member firm examinations. The burden of proof would be on the Floor broker to substantiate that a legitimate error occurred. 18 14 *See* proposed NYSE Rule 134(h)(ii). In Amendment No. 4 the Exchange added language to the proposed rule text to clarify that a system malfunction refers to the failure of physical equipment, devices and/or programming employed by the Floor broker or otherwise provided by the Exchange and used in the execution of orders. 15 *See* proposed NYSE Rule 134(j)(ii). 16 *See* proposed NYSE Rule 134(i). 17 The record must include the date and time of the error, the date and time the error was discovered, the size of the error, the stock in which the error occurred, the original instructions, the names of all involved parties including the client and any upstairs trader, a detailed narrative of how the error occurred, detail narrative of discussions with relevant parties, the steps taken to correct the error and the ultimate resolution of the error. *See* proposed NYSE Rule 134(j)(iii). 18 *See* proposed NYSE Rule 134(j)(iii). C. Proposed Amendments to NYSE Rule 411 When a Floor broker commits an error as to security, side or price, there are instances where the Floor broker issues a report to the customer as a result of the execution. Currently, pursuant to NYSE Rule 411, in instances where a Floor broker issued a report to a customer based on a transaction that was made outside of the customer's instructions on a not held order, the Floor broker would be required to rescind the report, thus leaving the customer's order unexecuted and disadvantaging the customer. To allow the Floor broker to utilize his or her error account or the error account of the member organization to alleviate any disadvantage to the customer, the Exchange proposes to amend NYSE Rule 411 to allow a Floor broker to treat “erroneous reports” 19 as “erroneous trades” when the Floor broker committed an error as to security, side, or price. 19 An “erroneous report” is a report of an execution that is incorrect as to stock, price or whether an execution actually took place. Pursuant to the proposed rule change, a Floor broker would be permitted to treat an “erroneous report” as an “erroneous trade” when the price and size of the order would have been executable in the market at or near the time of the erroneous transaction. Specifically, the erroneous report based on a transaction that was made in error as to security, side or price would stand, provided that the price and size of the erroneous report were within the range of prices and sizes in the specified security reported to the NYSE portion of the Consolidated Tape on the day in which the order was executed. 20 The Floor broker would be required to report the error to the customer, including explaining to the customer whether the error was favorable or unfavorable to the customer. 21 The Floor broker also would be required to document on a trade-by-trade basis, the name of the individual authorized to accept the erroneous report for the customer, the amount of the error and whether the error was favorable to the customer. 22 The Floor broker would then treat the erroneous report as though it was an erroneous trade and his or her error account would become the opposite side to the report. 23 In addition, the Floor broker would assume any loss incurred and any profit that resulted would be paid to the New York Stock Exchange Foundation 24 as currently required by NYSE Rule 411(a)(ii)(5). Thus, any disadvantage would be borne by the Floor broker who was responsible for committing the error, and not by the customer. 20 *See* proposed NYSE Rule 411(a)(iv)(1). 21 *See* proposed NYSE Rule 411(a)(iv)(2). 22 *See* proposed NYSE Rule 411(a)(iv)(3). 23 *See* proposed NYSE Rule 411(a)(iv)(4). 24 *See* proposed NYSE Rule 411(a)(iv)(5). III. Discussion The Commission finds that the proposed rule change is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities exchange. 25 In particular, the Commission believes that the proposal is consistent with Section 6(b)(5) of the Act, 26 which require that the rules of an exchange be designed to promote just and equitable principles of trade, remove impediments to, and perfect the mechanism of, a free and open market and a national market system, and, in general, protect investors and the public interest. The Commission believes that the proposed rules provide for a fair, transparent, and reasonable process in which NYSE Floor brokers can correct trading errors. In particular, the Commission believes that it is appropriate for the Exchange to codify and thus make transparent its processes regarding the use of a Floor Broker's error account. The Commission notes that the proposed rule change is designed to provide Floor brokers with greater flexibility in using error accounts to correct trading errors in a manner that is less burdensome for customers. The Commission also notes that the proposed rule change includes recordkeeping requirements that will help the Exchange to monitor any potential abuse of the rule. 25 In approving this proposed rule change, the Commission has considered the proposed rule's impact on efficiency, competition, and capital formation. *See* 15 U.S.C. 78c(f). 26 15 U.S.C. 78f(b)(5). Pursuant to Section 19(b)(2) of the Act, 27 the Commission finds good cause for approving the proposal prior to the thirtieth day after the publication of the proposal, as modified by Amendment No. 4, in the **Federal Register** . The revision to the proposed rule change made by Amendment No. 4 does not raise any novel or substantive regulatory issues, and simply clarifies the meaning of a term in the proposed rule change. Therefore, the Commission finds good cause for approving the amended proposal on an accelerated basis. 27 15 U.S.C. 78s(b)(2). IV. Solicitation of Comments Interested persons are invited to submit written data, views, and arguments concerning the proposed rule change, as modified by Amendment No. 4, including whether the proposed rule change is consistent with the Act. Comments may be submitted by any of the following methods: Electronic Comments • Use the Commission's Internet comment form ( *http://www.sec.gov/rules/sro.shtml* ); or • Send an e-mail to *rule-comments@sec.gov* . Please include File Number SR-NYSE-2006-28 on the subject line. Paper Comments • Send paper comments in triplicate to Nancy M. Morris, Secretary, Securities and Exchange Commission, Station Place, 100 F Street, NE., Washington, DC 20549-1090. All submissions should refer to File Number SR-NYSE-2006-28. This file number should be included on the subject line if e-mail is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site ( *http://www.sec.gov/rules/sro.shtml* ). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room. Copies of such filing also will be available for inspection and copying at the principal office of the Exchange. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Number SR-NYSE-2006-28 and should be submitted on or before July 3, 2007. V. Conclusion *It is therefore ordered* , pursuant to Section 19(b)(2) of the Act, 28 that the proposed rule change (SR-NYSE-2006-28), as modified by Amendment Nos. 2, 3, and 4, is hereby approved on an accelerated basis. 28 15 U.S.C. 78s(b)(2). For the Commission, by the Division of Market Regulation, pursuant to delegated authority. 29 29 17 CFR 200.30-3(a)(12). Florence E. Harmon, Deputy Secretary. [FR Doc. E7-11188 Filed 6-11-07; 8:45 am] BILLING CODE 8010-01-P SECURITIES AND EXCHANGE COMMISSION [Release No. 34-55846; File No. SR-NYSEArca-2007-48; SR-NYSEArca-2007-49] Self-Regulatory Organizations; NYSE Arca, Inc. and NYSE Arca Equities, Inc.; Notice of Filing and Immediate Effectiveness of Proposed Rule Changes Relating to an Increase in the Frequency of the Short Interest Reporting Requirements for Equity Trading Permit Holders and Options Trading Permit Holders June 1, 2007. Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”), 1 and Rule 19b-4 thereunder, 2 notice is hereby given that on May 24, 2007, NYSE Arca, Inc. (“Exchange” or “NYSE Arca”), by itself and through its wholly owned subsidiary NYSE Arca Equities, Inc. (“NYSE Arca Equities”), filed with the Securities and Exchange Commission (“Commission”) the proposed rule changes as described in Items I, II, and III below, which Items have been substantially prepared by the Exchange. The Exchange filed the proposals as “non-controversial” rule changes under Rule 19b-4(f)(6) under the Act, 3 which rendered the proposals effective upon filing with the Commission. The Commission is publishing this notice to solicit comments on the proposed rule changes from interested persons. 1 15 U.S.C. 78s(b)(1). 2 17 CFR 240.19b-4. 3 17 CFR 240.19b-4(f)(6). I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Changes A. NYSE Arca Equities Rule 4.5(e) The Exchange proposes to amend NYSE Arca Equities Rule 4.5(e) to reflect the Commission's adoption of Regulation SHO. 4 By this filing, the Exchange also shall clarify the short interest reporting requirements of Equity Trading Permit (“ETP”) Holders 5 as prescribed by Rule 4.5(e). While the changes to the reporting requirements of ETP Holders pursuant to this proposal will be effective upon filing, the changes will become operative in September 2007, consistent with the requirements of other representative organizations of the Intermarket Surveillance Group (“ISG”). 6 The text of the proposed rule change is available at the Exchange, at the Commission's Public Reference Room, and at *www.nyse.com* . 4 *See* Securities Exchange Act Release No. 34-50103 (July 28, 2004), 69 FR 48008 (August 6, 2004). *See also* 17 CFR 240.200 *et seq.* 5 *See* NYSE Arca Equities Rule 1.1(n). 6 *See* ISG Notice to Members 2007-01 (March 15, 2007), and American Stock Exchange Notice REG 2007-19 (March 16, 2007). B. NYSE Arca Rule 4.5(f) The Exchange also proposes to amend NYSE Arca Rule 4.5(f) to reflect the Commission's adoption of Regulation SHO. 7 By this filing, the Exchange also shall clarify the short interest reporting requirements of Options Trading Permit (“OTP”) Holders 8 and OTP Firms. 9 While the changes to the reporting requirements of OTP Holders and OTP Firms pursuant to this proposal will be effective upon filing, the changes will become operative in September 2007, consistent with the requirements of other representative organizations of the ISG. 10 The text of the proposed rule change is available at the Exchange, at the Commission's Public Reference Room, and at *http://www.nyse.com* . 7 *See* Securities Exchange Act Release No. 34-50103 (July 28, 2004), 69 FR 48008 (August 6, 2004). *See also* 17 CFR 240.200 *et seq.* 8 *See* NYSE Arca Rule 1.1(q). 9 *See* NYSE Arca Rule 1.1(r). 10 *See* ISG Notice to Members 2007-01 (March 15, 2007), and American Stock Exchange Notice REG 2007-19 (March 16, 2007). II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Changes In its filing with the Commission, the self-regulatory organization included statements concerning the purpose of and basis for the proposed rule changes and discussed any comments it received on the proposed rule changes. The text of these statements may be examined at the places specified in Item IV below. The self-regulatory organization has prepared summaries, set forth in Sections A, B, and C below, of the most significant aspects of such statements. A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Changes 1. Purpose a. NYSE Arca Equities Rule 4.5(e) The Exchange proposes to make certain minor technical amendments to NYSE Arca Equities Rule 4.5(e), Periodic Reports, as such rule makes references to rules under the Act that are no longer in effect. Specifically, Rule 4.5(e) makes reference to “short” sales, as defined by Rule 3b-3 under the Act. 11 In light of the adoption of Regulation SHO, the Exchange shall make the appropriate change to its rule text to remove references to Rule 3b-3 under the Act and correctly identify Rule 200(a) under the Act 12 where such definition of short sales may be found. Further, Rule 4.5(e) exempts ETP Holders from reporting short positions if such a position resulted from a sale specified in clause
(9)of paragraph
(e)of Rule 10a-1 under the Act. Since clause
(9)has been removed from Rule 10a-1(e) under the Act, the exemption to ETP Holders is no longer applicable, and shall be removed as a reference with NYSE Arca Equities Rule 4.5(e). 11 *See* 17 CFR 240.3b-3. 12 *See* 17 CFR 240.200(a). Additionally, the Exchange proposes to increase the frequency of periodic reports that ETP Holders must submit to the Exchange concerning short positions in securities, as prescribed by NYSE Arca Equities Rule 4.5(e), from monthly to twice per month. This increase in the frequency of such reports is consistent with similar changes recently approved by the Commission for the National Association of Securities Dealers, Inc. (“NASD”), the New York Stock Exchange LLC (“NYSE”), and the American Stock Exchange LLC (“Amex”). 13 13 *See* Securities Exchange Act Release No. 34-55406 (March 6, 2007), 72 FR 11071 (March 12, 2007) (SR-NASD-2006-131; SR-NYSE-2006-111; SR-Amex-2007-05). The Exchange shall implement the new periodic reporting requirements for short positions of ETP Holders in September 2007 to be consistent with the increased reporting requirements of other self-regulatory organizations. 14 14 *See* supra note 6. b. NYSE Arca Rule 4.5(f) The Exchange proposes to make certain minor technical amendments to NYSE Arca Rule 4.5(f), Periodic Reports, as such rule makes references to rules under the Act that are no longer in effect. Specifically, Rule 4.5(f) makes reference to “short” sales, as defined by Rule 3b-3 under the Act. 15 In light of the adoption of Regulation SHO by the Commission, the Exchange shall make the appropriate change to its rule text to remove references to Rule 3b-3 under the Act and correctly identify Rule 200(a) under the Act 16 where such definition of short sales may be found. Further, Rule 4.5(f) exempts OTP Holders and OTP Firms from reporting short positions if such a position resulted from a sale specified in clause
(9)of paragraph
(e)of Rule 10a-1 under the Act. Since clause
(9)has been removed from Rule 10a-1(e) under the Act, the exemption to OTP Holders and OTP Firms is no longer applicable, and shall be removed as a reference with NYSE Arca Rule 4.5(f). 15 *See* 17 CFR 240.3b-3. 16 *See* 17 CFR 240.200(a). Additionally, the Exchange proposes to increase the frequency of periodic reports that OTP Holders and OTP Firms must submit to the Exchange concerning short positions in securities, as prescribed by NYSE Arca Rule 4.5(f), from monthly to twice per month. This increase in the frequency of such reports is consistent with similar changes recently approved by the Commission for the NASD, NYSE, and the Amex. 17 17 *See* Securities Exchange Act Release No. 34-55406 (March 6, 2007), 72 FR 11071 (March 12, 2007) (SR-NASD-2006-131; SR-NYSE-2006-111; SR-Amex-2007-05). The Exchange shall implement the new periodic reporting requirements for short positions of OTP Holders and OTP Firms in September 2007 to be consistent with the increased reporting requirements of other self-regulatory organizations. 18 2. Statutory Basis 18 *See* supra note 10. The Exchange believes the proposed rule changes are consistent with Section 6(b) of the Act 19 in general and further the objectives of Section 6(b)(5) 20 in particular in that they are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in facilitating transactions in securities, and to remove impediments to and perfect the mechanism of a free and open market and a national market system. 19 15 U.S.C. 78f(b). 20 15 U.S.C. 78f(b)(5). B. Self-Regulatory Organization's Statement on Burden on Competition The Exchange does not believe that the proposed rule changes will impose any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act. C. Self-Regulatory Organization's Statement on Comments on the Proposed Rule Changes Received From Members, Participants or Others Written comments on the proposed rule changes were neither solicited nor received. III. Date of Effectiveness of the Proposed Rule Changes and Timing for Commission Action Because the foregoing proposed rule changes do not
(i)Significantly affect the protection of investors or the public interest,
(ii)impose any significant burden on competition, or
(iii)become operative within 30 days after the date of the filing, they have become effective upon filing pursuant to Section 19(b)(3)(A) of the Act 21 and Rule 19b-4(f)(6) 22 thereunder. 21 15 U.S.C. 78s(b)(3)(A). 22 17 CFR 19b-4(f)(6). At any time within 60 days of the filing of the proposed rule changes, the Commission may summarily abrogate such rule changes if it appears to the Commission that such action is necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of the Act. 23 23 *See* 15 U.S.C. 78s(b)(3)(C). IV. Solicitation of Comments Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule changes are consistent with the Act. Comments may be submitted by any of the following methods: Electronic Comments • Use the Commission's Internet comment form ( *http://www.sec.gov/rules/sro.shtml* ); or • Send an e-mail to *rule-comments@sec.gov.* Please include File No. SR-NYSEArca-2007-48 or SR-NYSEArca-2007-49 on the subject line. Paper Comments • Send paper comments in triplicate to Nancy M. Morris, Secretary, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090. All submissions should refer to File No. SR-NYSEArca-2007-48 or SR-NYSEArca-2007-49. This file number should be included on the subject line if e-mail is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site ( *http://www.sec.gov/rules/sro.shtml* ). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule changes that are filed with the Commission, and all written communications relating to the proposed rule changes between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room. Copies of such filing also will be available for inspection and copying at the principal offices of the Exchange. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File No. SR-NYSEArca-2007-48 or SR-NYSEArca-2007-49 and should be submitted on or before July 3, 2007. For the Commission, by the Division of Market Regulation, pursuant to delegated authority. 24 24 17 CFR 200.30-3(a)(12). Florence E. Harmon, Deputy Secretary. [FR Doc. E7-11266 Filed 6-11-07; 8:45 am] BILLING CODE 8010-01-P DEPARTMENT OF TRANSPORTATION Federal Aviation Administration Aviation Rulemaking Advisory Committee—New Task AGENCY: Federal Aviation Administration (FAA), DOT. ACTION: Notice of new task assignment for the Aviation Rulemaking Advisory Committee (ARAC). SUMMARY: The FAA assigned the Aviation Rulemaking Advisory Committee a new task to: Review and recommend revisions to certain requirements for operation of aviation maintenance technician schools. This notice is to inform the public of this ARAC activity. FOR FURTHER INFORMATION CONTACT: Ferrin Moore, Aircraft Maintenance Division, AFS-301, Federal Aviation Administration, 800 Independence Avenue, SW., Washington, DC 20591; telephone
(202)267-3809, e-mail *ferrin.c.moore@faa.gov.* SUPPLEMENTARY INFORMATION: Background The FAA established the Aviation Rulemaking Advisory Committee to provide advice and recommendations to the FAA Administrator on the FAA's rulemaking activities with respect to aviation-related issues. This includes obtaining advice and recommendations on 14 CFR Part 147—Aviation Maintenance Technician Schools. In order to develop such advice and recommendations, the ARAC may choose to establish working groups to which specific tasks are assigned. Such working groups are comprised of experts from those organizations having an interest in the assigned tasks. A working group member need not be representative of the full committee. The Aviation Maintenance Technician Schools Curriculum and Operating Requirements Working Group is a new working group that is being established by the ARAC. A review of General Accounting Office Report GAO-03-317, dated March 2003, indicates a need to update the curriculum requirements for aviation mechanics. Currently, FAA certificated Aviation Maintenance Technician Schools must offer a curriculum that addresses each of the subject areas described in 14 CFR, Part 147, Appendices B, C, and D. Each subject area must be taught to the level prescribed, and as defined in 14 CFR, Part 147, Appendix A. In addition, § 147.21(b) of Part 147 mandates the number of teaching hours devoted to each group of subject areas (General, Airframe, and Powerplant). These hours are: General—400, Airframe—750, Powerplant—750. A total of 1,900 hours is needed for a combined Airframe and Powerplant curriculum. In addition, the FAA has issued exemptions to aviation maintenance technician schools enabling the schools to substitute experience required in § 65.77 for subject hours. Section 65.75(a) prescribes, in pertinent part, that applicants must pass a written test after meeting the experience requirements of § 65. 77. Section 65.77 also requires applicants to complete training and present an appropriate graduation certificate or certificate of completion from a certificated aviation maintenance technician school before being eligible to take the written test for a certificate or rating. Task
(1)The working group is tasked to evaluate §§ 147.21 and 147.31 and appendices A through D of 14 CFR Part 147, and make recommendations to ARAC that would enable the AMT schools to meet the needs of their clientele more effectively. The working group is tasked to recommend revisions to 14 CFR Part 147 to contain some basic, consistent, requirements. The objective is to provide an easier means to keep current training curricula, training criteria, and hours of training, while remaining within the minimum requirements outlined in §§ 147.21 and 147.31, and appendices A through D of 14 CFR Part 147. As part of its task, the working group will review available information about general curriculum requirements and specific operating rules for attendance and enrollment, tests, and credit for prior instruction or experience that could be applicable to meeting the requirements of §§ 147.21 and 147.31 and appendices A through D of 14 CFR Part 147.
(2)In addition, the working group is tasked to evaluate and incorporate, as appropriate, revisions granted by exemption to §§ 65.75(a) and 65.77 of 14 CFR Part 65. The working group should consider the appropriateness of modifying § 65.75(a) to allow students enrolled in Part 147 Aviation Maintenance Technician Schools to take the Aviation Mechanic written tests after completing the corresponding portion of the curriculum, but before meeting the experience requirements of § 65.77. Section 65.77 prescribes, in pertinent part, that each applicant for a mechanic certificate or rating must present either an appropriate graduation certificate or a certificate of completion from a certificated aviation maintenance technician school or documented evidence, satisfactory to the Administrator before certification. The FAA has issued grants of exemption to allow students to take equivalency tests for the aviation maintenance airframe and aviation maintenance powerplant ratings certification. The FAA agreed with the petitioners that testing immediately after completing a course is academically sound. ARAC will make recommendations to the FAA, as appropriate, for revising these requirements and associated guidance material. *Schedule:* Required completion is no later than 9 months after the first working group meeting or June 30, 2008, whichever occurs first. ARAC Acceptance of Task ARAC accepted the task and assigned the task to the Aviation Maintenance Technician Schools Curriculum and Operating Requirements Working Group, which is being formed and will be managed by the Executive Committee of ARAC. The working group serves as staff to ARAC and assists in the analysis of assigned tasks. ARAC must review and approve the working group's recommendations. If ARAC accepts the working group's recommendations, it will forward them to the FAA. The FAA will submit the recommendations it receives to the agency's Rulemaking Management Council to address the availability of resources and priority within its rulemaking program. Working Group Activity The Aviation Maintenance Technician Schools Curriculum and Operating Requirements Working Group must comply with the procedures adopted by ARAC. As part of the procedures, the working group must: 1. Recommend a work plan for completion of the task, including the rationale supporting such a plan for consideration at the next Executive Committee meeting of ARAC held following publication of this notice. 2. Give a detailed conceptual presentation of the proposed recommendations before proceeding with the work stated in item 3 below. 3. If proposed rule changes are recommended, provide supporting economic and other required analyses. If new or revised requirements or compliance methods are not recommended, a draft report stating the rationale for not making such recommendations; and 4. Provide a status report at each Executive Committee meeting of the ARAC. Participation in the Working Group The Aviation Maintenance Technician Schools Curriculum and Operating Requirements Working Group will be composed of technical experts having an interest in the assigned task. A working group member need not be a representative or a member of the Aviation Rulemaking Advisory Committee. Membership of the working group will have broad experience in developing curriculum and operating requirements for maintenance technician schools. The working group may organize, oversee, guide and monitor activities and progress of subject matter experts as needed to accomplish the task assigned. The working group chair and the FAA representative will select the membership for the working group, with concurrence of the Executive Committee of ARAC and the FAA. Subject matter experts will address individual issues and will be invited to present their views and positions for consideration by the working group. This allows for an optimum working group size with appropriate representation to achieve informed consensus and foster successful completion of the task. This may also allow the participation of a large number of cross-functional subject matter experts. The working group members should have the appropriate subject matter knowledge, broad maintenance curriculum development experience and responsibility within their organization and authority to represent their respective part of the aviation community. If you have expertise in the subject matter and wish to become a member of the working group, write to the person listed under the caption FOR FURTHER INFORMATION CONTACT expressing that desire. Describe your interest in the task and state the expertise you would bring to the working group. We must receive all requests by July 17, 2007. The Executive Committee and the FAA will review the requests and advise you whether or not your request is approved. If you are chosen for membership on the working group, you must represent your aviation community segment and actively participate in the working group by attending all meetings, and providing written comments when requested to do so. You must devote the resources necessary to support the working group in meeting any assigned deadlines. You must keep your management chain and those you may represent advised of working group activities and decisions to ensure that the proposed technical solutions don't conflict with your sponsoring organization's position when the subject is presented to the Executive Committee for approval. Once the working group has begun deliberations, members will not be added or substituted without the approval of the Executive Committee, FAA and the working group chair. The Secretary of Transportation determined that the formation and use of the ARAC is necessary and in the public interest in connection with the performance of duties imposed on the FAA by law. Meetings of the Executive Committee of ARAC are open to the public. Meetings of the Aviation Maintenance Technician Schools Curriculum and Operating Requirements Working Group will not be open to the public, except to the extent individuals with an interest and expertise are selected to participate. The FAA will make no public announcement of working group meetings. Issued in Washington, DC, on June 1, 2007. Pamela Hamilton-Powell, Executive Director, Aviation Rulemaking Advisory Committee. [FR Doc. E7-11260 Filed 6-11-07; 8:45 am] BILLING CODE 4910-13-P DEPARTMENT OF TRANSPORTATION National Highway Traffic Safety Administration [Docket No. NHTSA-2007-28430, Notice 1] Mosler Automotive; Receipt of Application for a Temporary Exemption From the Advanced Air Bag Requirements of FMVSS No. 208 AGENCY: National Highway Traffic Safety Administration (NHTSA), Department of Transportation (DOT). ACTION: Notice of receipt of petition for temporary exemption from provisions of Federal Motor Vehicle Safety Standard (FMVSS) No. 208, *Occupant Crash Protection* . SUMMARY: In accordance with the procedures in 49 CFR Part 555, Mosler Automotive has petitioned the agency for a temporary exemption from certain advanced air bag requirements of FMVSS No. 208. The basis for the application is that compliance would cause substantial economic hardship to a manufacturer that has tried in good faith to comply with the standard. 1 1 To view the application, go to: *http://dms.dot.gov/search/searchFormSimple.cfm* and enter the docket number set forth in the heading of this document. This notice of receipt of an application for temporary exemption is published in accordance with the statutory provisions of 49 U.S.C. 30113(b)(2). NHTSA has made no judgment on the merits of the application. DATES: You should submit your comments not later than July 12, 2007. FOR FURTHER INFORMATION CONTACT: Mr. Ed Glancy or Ms. Rebecca Schade, Office of the Chief Counsel, NCC-112, National Highway Traffic Safety Administration, 1200 New Jersey Avenue, SE., West Building 4th Floor, Room W41-326, Washington, DC 20590. Telephone:
(202)366-2992; Fax:
(202)366-3820. *Comments:* We invite you to submit comments on the application described above. You may submit comments identified by docket number at the heading of this notice by any of the following methods: • *Web Site: http://dms.dot.gov* . Follow the instructions for submitting comments on the DOT electronic docket site by clicking on “Help and Information” or “Help/Info.” • *Fax:* 1-202-493-2251. • *Mail:* U.S. Department of Transportation, Docket Operations, M-30, Room W12-140, 1200 New Jersey Avenue, SE., Washington, DC 20590. • *Hand Delivery:* 1200 New Jersey Avenue, SE., West Building Ground Floor, Room W12-140, Washington, DC, between 9 a.m. and 5 p.m., Monday through Friday, except Federal holidays. • *Federal eRulemaking Portal:* Go to *http://www.regulations.gov* . Follow the online instructions for submitting comments. *Instructions:* All submissions must include the agency name and docket number or Regulatory Identification Number
(RIN)for this rulemaking. For detailed instructions on submitting comments and additional information on the rulemaking process, see the Public Participation heading of the SUPPLEMENTARY INFORMATION section of this document. Note that all comments received will be posted without change to *http://dms.dot.gov* , including any personal information provided. Please see the Privacy Act discussion under the Public Participation heading. *Docket:* For access to the docket to read background documents or comments received, go to *http://dms.dot.gov* at any time or to 1200 New Jersey Avenue, SE., West Building Ground Floor, Room W12-140, Washington, DC 20590, between 9 a.m. and 5 p.m., Monday through Friday, except Federal holidays. Telephone:
(202)366-9826. *Privacy Act:* Anyone is able to search the electronic form of all comments received into any of our dockets by the name of the individual submitting the comment (or signing the comment, if submitted on behalf of an association, business, labor union, etc.). You may review DOT's complete Privacy Act Statement in the **Federal Register** published on April 11, 2000 (Volume 65, Number 70; Pages 19477-78) or you may visit *http://dms.dot.gov* . We shall consider all comments received before the close of business on the comment closing date indicated above. To the extent possible, we shall also consider comments filed after the closing date. I. Advanced Air Bag Requirements and Small Volume Manufacturers In 2000, NHTSA upgraded the requirements for air bags in passenger cars and light trucks, requiring what are commonly known as “advanced air bags.” 2 The upgrade was designed to meet the goals of improving protection for occupants of all sizes, belted and unbelted, in moderate-to-high-speed crashes, and of minimizing the risks posed by air bags to infants, children, and other occupants, especially in low-speed crashes. 2 See 65 FR 30680 (May 12, 2000). The advanced air bag requirements were a culmination of a comprehensive plan that the agency announced in 1996 to address the adverse effects of air bags. This plan also included an extensive consumer education program to encourage the placement of children in rear seats. The new requirements were phased in beginning with the 2004 model year. Small volume manufacturers were not subject to the advanced air bag requirements until September 1, 2006, but their efforts to bring their respective vehicles into compliance with these requirements began several years before that. However, because the new requirements were challenging, major air bag suppliers have concentrated their efforts on working with large volume manufacturers, and thus, until recently, small volume manufacturers had limited access to advanced air bag technology. Because of the nature of the requirements for protecting out-of-position occupants, “off-the-shelf” systems could not be readily adopted. Further complicating matters, because small volume manufacturers build so few vehicles, the costs of developing custom advanced air bag systems compared to potential profits discouraged some air bag suppliers from working with small volume manufacturers. The agency has carefully tracked occupant fatalities resulting from air bag deployment. Our data indicate that the agency's efforts in the area of consumer education and manufacturers' providing depowered air bags were successful in reducing air bag fatalities even before advanced air bag requirements were implemented. As always, we are concerned about the potential safety implication of any temporary exemptions granted by this agency. In the present case, we are seeking comments on a petition for a temporary exemption from the advanced air bag requirements submitted by a manufacturer of very expensive, low volume, exotic sports cars. II. Overview of Petition for Economic Hardship Exemption In accordance with 49 U.S.C. 30113 and the procedures in 49 CFR part 555, Mosler Automotive has petitioned the agency for a temporary exemption from certain advanced air bag requirements of FMVSS No. 208. The basis for the application is that compliance would cause substantial economic hardship to a manufacturer that has tried in good faith to comply with the standard. A copy of the petition 3 is available for review and has been placed in the docket for this notice. 3 The company requested confidential treatment under 49 CFR Part 512 for certain business and financial information submitted as part of its petition for temporary exemption. Accordingly, the information placed in the docket does not contain information subject to a claim of confidentiality. III. Statutory Background for Economic Hardship Exemptions A manufacturer is eligible to apply for a hardship exemption if its total motor vehicle production in its most recent year of production did not exceed 10,000 vehicles, as determined by the NHTSA Administrator (49 U.S.C. 30113). In determining whether a manufacturer of a vehicle meets that criterion, NHTSA considers whether a second vehicle manufacturer also might be deemed the manufacturer of that vehicle. The statutory provisions governing motor vehicle safety (49 U.S.C. Chapter 301) do not include any provision indicating that a manufacturer might have substantial responsibility as a manufacturer of a vehicle simply because it owns or controls a second manufacturer that assembled that vehicle. However, the agency considers the statutory definition of “manufacturer” (49 U.S.C. 30102) to be sufficiently broad to include sponsors, depending on the circumstances. Thus, NHTSA has stated that a manufacturer may be deemed to be a sponsor and thus a manufacturer of a vehicle assembled by a second manufacturer if the first manufacturer had a substantial role in the development and manufacturing process of that vehicle. IV. Petition of Mosler Automotive *Background.* Mosler Automotive is a U.S. company, organized as a Florida corporation in 1987 and owned by a single American shareholder. Mosler began production in 1998 of high performance sports cars based on an aluminum honeycomb monocoque chassis. This application concerns the MT900 (MY 2004, currently the company's only model), which is expected to retail for $189,900. To date, the MT900 has been in and out of production, with the following numbers of vehicles being produced over the past three years: 12 vehicles in 2004; 8 vehicles in 2005; and 13 vehicles in 2006. Worldwide sales, as of the time of the petition, were 10 race cars, 3 U.S. street cars, and 8 European specification cars. According to the petition, the company has determined that it cannot finance the work necessary to develop and install advanced air bags in its vehicles unless U.S. sales continue. It argued that NHTSA has previously “confirmed the appropriateness of an exemption when the sales of exempted vehicles generate income to fund air bag development expenditures in order to comply with Standard 208 at the end of the exemption period. 64 FR 6736.” Mosler Automotive stated that it “therefore needs USA exempted-vehicle sales to ‘bridge the gap.’ ” The petitioner further stated that it “will suffer a significant market loss—the U.S.—in the event it does not receive the exemption.” The petitioner argued that it tried in good faith, but could not bring the vehicle into compliance with the advanced air bag requirements, and would incur substantial economic hardship if it cannot sell vehicles in the U.S. Mosler Automotive has an extremely long product cycle (for the MT900, the company estimates a lifespan of 11 years), which has thus far prevented it from recouping its $600,000 investment in its current standard air bag occupant restraint system. The petitioner states that significant engineering and funding will be necessary to upgrade to an advanced air bag system, and that the projected overall cost of approximately $2.0 to $2.5 million is beyond the company's current capabilities. *Eligibility.* As discussed in the petition, Mosler Automotive is independently owned by a single American shareholder. The entire organization currently employs 25 people in the U.S. No other vehicle manufacturer has an ownership interest in Mosler Automotive. Stated another way, Mosler Automotive is an independent automobile manufacturer which does not have any common control nor is otherwise affiliated with any other vehicle manufacturer. The company is a small volume manufacturer whose total production has ranged from 8 to 13 vehicles per year over the period from 2004 to 2006. According to its current forecasts, Mosler Automotive anticipates that approximately 75 vehicles would be sold in the U.S. during the three-year period for its requested exemption, if such request were granted. *Requested exemption.* Mosler Automotive is requesting an exemption for the MT900 from all of the advanced air bag requirements in S14 of FMVSS No. 208, the rigid barrier test requirement using the 5th percentile adult female test dummy (belted and unbelted, S15), the offset deformable barrier test requirement using the 5th percentile adult female test dummy (S17), the requirements to provide protection for infants and children (S19, S21, and S23) and the requirement using an out-of-position 5th percentile adult female test dummy at the driver position (S25). Mosler Automotive stated its intention to have its advanced air bag system ready in 2009. Accordingly, the company seeks an exemption from the above-specified requirements of FMVSS No. 208 from June 1, 2007 to December 31, 2009. *Economic hardship.* Publicly available information and also the financial documents submitted to NHTSA by the petitioner indicate that the MT900 project will result in financial losses unless Mosler Automotive obtains a temporary exemption. Over the period 2004-2006, Mosler Automotive has had net operational losses totaling over $3 million, and the retained deficit of the company exceeds over $23 million. The costs associated with development of an advanced air bag system for the vehicle have been estimated at about $2.0 to $2.5 million. The company has stated that it cannot hope to attain profitability if it incurs additional research and development expenses at this time. Mosler Automotive stated that the estimated $2.0 to $2.5 million in costs associated with advanced air bag engineering and development included research and development, testing, tooling, and test vehicles, as well as internal costs. In its petition, Mosler Automotive reasoned that sales in the U.S. market must commence in order to finance this work and that non-U.S. sales alone cannot generate sufficient income for this purpose. In essence, Mosler Automotive argued that the exemption is necessary to allow the company to “bridge the gap” until fully compliant vehicles can be funded, developed, tooled, and introduced for the U.S. market. If the exemption is denied, Mosler Automotive projects a net loss of over $3 million during the period from 2007-2009. However, if the petition is granted, the company anticipates a profit of nearly $6.4 million during that same period. The petitioner argued that a denial of this petition could preclude financing of the project for U.S.-compliant vehicles, a development which would have a highly adverse impact on the company. *Good faith efforts to comply.* Mosler Automotive began production of the latest version of the MT900 in 2004, at which time it was certified for U.S. road use. The company has invested over $23 million on research and development and tooling for the MT900 program. In that time, the company was able to bring the vehicle into compliance with all applicable NHTSA regulations, except for the advanced air bag provisions of FMVSS No. 208. In light of limited resources, the petitioner stated that it was necessary to first develop the vehicle with a standard U.S. air bag system. The company has spent $600,000 to re-engineer the MT900 to include a standard air bag system, which it stated will then be developed into an advanced air bag system. According to its petition, even though advanced air bags are beyond its current capabilities, Mosler Automotive is nonetheless planning for the introduction of these devices. The company stated that Siemens Restraint Systems will spearhead this effort, and current plans estimate a cost of between $2.0 and $2.5 million (excluding internal costs) and a minimum lead time of 24 months for the advanced air bag project. Mosler Automotive stated that the following engineering efforts are needed to upgrade the MT900's standard air bag system to an advanced air bag system:
(1)Tooling for prototypes and production vehicles;
(2)contractor engineering;
(3)air bag system materials;
(4)cost of test vehicles;
(5)integration of air bag electronics;
(6)radio frequency interference/electromagnetic compatibility testing;
(7)significant design and development of interior components including seats and dashboard;
(8)crash testing; and
(9)system validation. NHTSA notes that this estimate is based on a quotation from Siemens that appears to have expired, and has requested updated information from the petitioner to ensure that the estimate is still accurate. In addition, Mosler Automotive emphasized that finding suppliers willing to work with a manufacturer with very low production volumes has proven extremely difficult, and as a result, the company must wait for technology to “trickle down” from larger manufacturers and suppliers. Mosler Automotive further stated that, as a small volume manufacturer, the company simply does not have the internal resources to do full U.S. homologation projects without reliance on outside suppliers of advanced engineering technologies. In short, Mosler Automotive argued that, despite good faith efforts, limited resources prevent it from bringing the vehicle into compliance with all applicable requirements, and it is beyond the company's current capabilities to bring the vehicle into full compliance until such time as additional resources become available as a result of U.S. sales. Mosler Automotive stated in its petition that it expects its advanced air bag system to be ready in 2009, and that an exemption would allow it to maintain continued operations until then. *Mosler Automotive argues that an exemption would be in the public interest.* The petitioner put forth several arguments in favor of a finding that the requested exemption is consistent with the public interest and would not have a significant adverse impact on safety. Specifically, Mosler Automotive argued that the vehicle would be equipped with a fully-compliant standard U.S. air bag system ( *i.e.* , one meeting all requirements of FMVSS No. 208 prior to implementation of S14). Furthermore, the company emphasized that the MT900 will comply with all other applicable FMVSSs. The company asserted that granting the exemption will benefit U.S. employment, companies, and citizens, because Mosler Automotive is a U.S. company and employs 25 people at its Florida facility. Mosler Automotive also argued that denial of the exemption request would have an adverse impact on consumer choice. The company also argued that an exemption is unlikely to have a significant safety impact because these vehicles are not expected to be used extensively by their owners, due to their “second vehicle” nature, extreme design and high cost. The company also reasoned that given the nature of the vehicle, it is less likely to be used to transport young children than most other vehicles. As an additional basis for showing that its requested exemption would be in the public interest, Mosler Automotive stated that the MT900 has an extremely strong chassis, which is composed of aluminum tubes and composite structural parts. According to Mosler Automotive, the vehicle design is such that occupants are effectively placed in a “protective ‘cell’ ” with the chassis structure built around them. V. Issuance of Notice of Final Action We are providing a 30-day comment period. After considering public comments and other available information, we will publish a notice of final action on the application in the **Federal Register** . Issued on: June 5, 2007. Stephen R. Kratzke, Associate Administrator for Rulemaking. [FR Doc. E7-11259 Filed 6-11-07; 8:45 am] BILLING CODE 4910-59-P DEPARTMENT OF VETERANS AFFAIRS Health Outcomes Not Associated With Exposure to Certain Herbicide Agents AGENCY: Department of Veterans Affairs. ACTION: Notice. SUMMARY: As required by law, the Department of Veterans Affairs
(VA)hereby gives notice that the Secretary of Veterans Affairs, under authority of the Veterans Education and Benefits Expansion Act of 2001, Public Law 107-103, Section 201(d), has determined that a presumption of service connection is not warranted based on exposure to herbicides used in the Republic of Vietnam during the Vietnam Era for the following health outcomes: Hepatobiliary cancers; oral, nasal, and pharyngeal cancer; bone and joint cancer; skin cancers (melanoma, basal, and squamous cell); breast cancer; female reproductive cancer (cervix, uterus, and ovary); testicular cancer; urinary bladder cancer; renal cancer; leukemia (other than chronic lymphocytic leukemia (CLL)); abnormal sperm characteristics and infertility; spontaneous abortion; neonatal or infant death and stillbirth in offspring of exposed individuals; low birthweight in offspring of exposed individuals; neurobehavioral disorders (cognitive and neuropsychiatric); movement disorders including Parkinson's disease and amyotrophic lateral sclerosis (ALS); chronic peripheral nervous system disorders; respiratory disorders; gastrointestinal, metabolic, and digestive disorders (changes in liver enzymes, lipid abnormalities, ulcers); immune system disorders (immune suppression, autoimmunity); circulatory disorders; amyloid light-chain
(AL)amyloidosis; endometriosis; effects on thyroid homeostasis; gastrointestinal tumors (esophagus, stomach, pancreas, colon, rectum; brain tumors; and any other condition for which the Secretary has not specifically determined a presumption of service connection is warranted. The Secretary's determinations regarding individual diseases are based on all available evidence in a 2004 report of the National Academy of Sciences
(NAS)and prior NAS reports. This notice generally states specific information only with respect to significant additional studies that were first reviewed by NAS in its 2004 report. Information regarding additional relevant studies is stated in VA's prior notices following earlier NAS reports, and will not be repeated here. FOR FURTHER INFORMATION CONTACT: Rhonda F. Ford, Consultant, Regulations Staff, Compensation and Pension Service, Veterans Benefits Administration, Department of Veterans Affairs, 810 Vermont Avenue, NW., Washington, DC 20420,
(202)273-7210. SUPPLEMENTARY INFORMATION: Section 3 of the Agent Orange Act of 1991, Public Law 102-4, 105 Stat. 11, directed the Secretary to seek to enter into an agreement with the National Academy of Sciences
(NAS)to review and summarize the scientific evidence concerning the association between exposure to herbicides used in support of military operations in the Republic of Vietnam during the Vietnam Era and each disease suspected to be associated with such exposure. Congress mandated that NAS determine, to the extent possible:
(1)Whether there is a statistical association between the suspect diseases and herbicide exposure, taking into account the strength of the scientific evidence and the appropriateness of the methods used to detect the association;
(2)the increased risk of disease among individuals exposed to herbicides during service in the Republic of Vietnam during the Vietnam Era; and
(3)whether there is a plausible biological mechanism or other evidence of a causal relationship between herbicide exposure and the health outcome. Section 3 of Public Law 102-4 also required that NAS submit reports on its activities every two years (as measured from the date of the first report) for a ten-year period. Section 2 of Public Law 102-4, codified in pertinent part at 38 U.S.C. 1116(b) and (c), provides that whenever the Secretary determines, based on sound medical and scientific evidence, that a positive association (i.e. the credible evidence for the association is equal to or outweighs the credible evidence against the association) exists between exposure of humans to an herbicide agent (i.e. a chemical in an herbicide used in support of the United States and allied military operations in the Republic of Vietnam during the Vietnam Era) and a disease, the Secretary will publish regulations establishing presumptive service connection for that disease. If the Secretary determines that a presumption of service connection is not warranted, he is to publish a notice of that determination, including an explanation of the scientific basis for that determination. The Secretary's determination must be based on consideration of the NAS reports and all other sound medical and scientific information and analysis available to the Secretary. Section 2 of the Agent Orange Act of 1991 provided that the Secretary's authority and duties under that section would expire 10 years after the first day of the fiscal year in which NAS transmitted its first report to VA. The first NAS report was transmitted to VA in July 1993, during the fiscal year that began on October 1, 1992. Accordingly, VA's authority under section 2 of the Agent Orange Act of 1991 expired on September 30, 2002. In December 2001, however, Congress enacted the Veterans Education and Benefits Expansion Act of 2001, Public Law 107-103. Section 201(d) of that Act extended VA's authority under 38 U.S.C. 1116(b)-(d) through September 30, 2015. Although 38 U.S.C. 1116 does not define “credible,” it does instruct the Secretary to “take into consideration whether the results [of any study] are statistically significant, are capable of replication, and withstand peer review.” The Secretary reviews studies that report a positive relative risk and studies that report a negative relative risk of a particular health outcome. He then determines whether the weight of evidence supports a finding that there is or is not a positive association between herbicide exposure and the subsequent health outcome. The Secretary does this by taking into account the statistical significance, capability of replication, and whether that study will withstand peer review. Because of differences in statistical significance, confidence levels, control for confounding factors, bias, and other pertinent characteristics, some studies are more credible than others. The Secretary gives weight to more credible studies in evaluating the overall evidence concerning specific health outcomes. Chronology NAS issued its initial report, entitled “Veterans and Agent Orange: Health Effects of Herbicides Used in Vietnam,”
(VAO)on July 27, 1993. The Secretary subsequently determined that a positive association exists between exposure to herbicides used in the Republic of Vietnam and the subsequent development of Hodgkin's disease, porphyria cutanea tarda, multiple myeloma, and certain respiratory cancers. The Secretary also determined that there was no positive association between herbicide exposure and any other health outcome, other than chloracne, non-Hodgkin's lymphoma, and soft-tissue sarcomas, for which presumptions already existed. A notice of the health outcomes that the Secretary determined were not associated with exposure to herbicides was published on January 4, 1994. (See 59 FR 341 (1994)). NAS issued its second report, entitled “Veterans and Agent Orange: Update 1996” (Update 1996), on March 14, 1996. The Secretary subsequently determined that a positive association exists between exposure to herbicides used in the Republic of Vietnam and the subsequent development of prostate cancer and acute and subacute peripheral neuropathy in exposed persons. The Secretary further determined that there was no positive association between herbicide exposure and any other condition, other than those for which presumptions already existed. A notice of the diseases that the Secretary determined were not associated with exposure to herbicide agents was published on August 8, 1996. (See 61 FR 41442 (1996)). NAS issued a third report, entitled “Veterans and Agent Orange: Update 1998” (Update 1998), on February 11, 1999. The focus of this update was new scientific studies published since the release of Update 1996 and updates of scientific studies previously reviewed. After NAS issued Update 1998, the Secretary determined that there was no positive association between herbicide exposure and any other condition, other than those for which presumptions already existed. A notice of the health outcomes that the Secretary determined were not associated with exposure to herbicide agents was published on November 2, 1999. (See 64 FR 59232 (1999)). At VA's request, NAS issued a special interim report, “Veterans and Agent Orange: Herbicide/Dioxin Exposure and Type 2 Diabetes” (VAO: Diabetes) on October 11, 2000. NAS concluded that: “there is limited/suggestive evidence of an association between exposure to the herbicides used in Vietnam or the contaminant dioxin and Type 2 diabetes.” NAS based its conclusion on the conglomeration of scientific evidence, not one particular study. (VAO: Diabetes.) After considering all of the evidence, the Secretary determined that there is a positive association between exposure to herbicides and Type 2 diabetes and, therefore, a presumption of service connection was warranted. (See 66 FR 2376 (2001)). NAS issued a fourth report, entitled “Veterans and Agent Orange: Update 2000” (Update 2000), on April 19, 2001. The focus of this update was the new scientific studies published since the release of Update 1998 and updates of scientific studies previously reviewed. After NAS issued Update 2000, the Secretary determined that there was no positive association between herbicide exposure and any other condition, other than those for which presumptions already existed. A notice of the health outcomes that the Secretary determined were not associated with exposure to herbicide agents was published in June 24, 2002 (See 67 FR 42600 (2002)). NAS issued its fifth report, entitled “Veterans and Agent Orange: Update 2002” (Update 2002) on January 23, 2003. The focus of this update was the new scientific studies published since the release of Update 2000 and review of the studies previously reviewed along with the newest scientific evidence. The Secretary subsequently determined that a positive association exists between exposure to herbicides used in the Republic of Vietnam and the subsequent development of chronic lymphocytic leukemia
(CLL)in exposed persons. After NAS issued Update 2002, the Secretary determined that there was no positive association between herbicide exposure and any other condition, other than those for which presumptions already existed. A notice of the health outcomes the Secretary determined were not associated with exposure to herbicide agents was published on May 20, 2003 (See 68 FR 27630 (2003)). Update 2004 NAS issued its sixth report entitled “Veterans and Agent Orange: Update 2004” (Update 2004) on March 4, 2005. Consistent with its prior reports, NAS in Update 2004 found that there was “sufficient evidence of an association” between herbicide exposure and five categories of diseases in veterans and “limited/suggestive evidence” of an association between herbicide exposure and six other categories of diseases in veterans. VA has previously established presumptions of service connection for each of these diseases. NAS, in Update 2004, categorized certain health outcomes to have “inadequate/insufficient” evidence to determine whether an association exists. This category is defined to mean that the available studies are of insufficient quality, consistency, or statistical power to permit a conclusion regarding the presence or absence of an association with herbicide exposure. Health outcomes that met the inadequate/insufficient category include: Hepatobiliary cancers; oral, nasal, and pharyngeal cancer; bone and joint cancer; skin cancers (melanoma, basal, and squamous cell); breast cancer; female reproductive system cancer (cervix, uterus, ovary); testicular cancer; urinary bladder cancer; renal cancer; leukemia (other than chronic lymphocytic leukemia (CLL)); abnormal sperm characteristics and infertility; spontaneous abortion; neonatal or infant death and stillbirth in offspring of exposed individuals; low birthweight in offspring of exposed individuals; birth defects (other than spina bifida) in offspring of exposed individuals; childhood cancer (including acute myelogenous leukemia) in offspring of exposed individuals; neurobehavioral disorders (cognitive and neuropsychiatric); movement disorders, including Parkinson's disease and amyotrophic lateral sclerosis (ALS); chronic peripheral nervous system disorders; respiratory disorders; gastrointestinal, metabolic, and digestive disorders (changes in liver enzymes, lipid abnormalities, ulcers); immune system disorders (immune suppression, autoimmunity); circulatory disorders; AL amyloidosis; endometriosis; and effects of thyroid homeostasis. In this same report, NAS found two health outcomes that fell into the “limited or suggestive evidence of no association category. These health outcomes were deemed consistent in not showing a positive association between them and any magnitude of exposure to herbicides. Those health outcomes that met the “no association” category were: gastrointestinal tumors (esophagus, stomach, pancreas, colon, rectum), and brain tumors. The Secretary's determinations regarding individual diseases are based on all available evidence in Update 2004 and prior NAS reports. This notice generally states specific information only with respect to significant additional studies that were first reviewed by NAS in Update 2004. Information regarding additional relevant studies has been stated in VA's prior notices following earlier NAS reports, and will not be repeated here. Hepatobiliary Cancers Hepatobiliary cancers are cancers of the liver and intrahepatic bile ducts. There are a variety of known risk factors, including chronic infections with hepatitis B or C, exposure to aflatoxin, vinyl chloride and polychlorinated biphenyl (PCB), and smoking, which should be considered by a credible study. NAS noted in VAO and subsequent reports that there were relatively few occupational, environmental, or veteran studies of hepatobiliary cancer. It also noted that most of the few existing studies addressing hepatobiliary cancer contain methodological difficulties such as small study size and inadequate control for life-style-related risk factors, or do not support an association with herbicide exposure. An occupational study by Swaen *et al.*
(2004)examined cancer mortality in herbicide appliers in the Netherlands, and no deaths from liver or biliary cancer were observed in the cohort. NAS found that there was no information contained in the research reviewed for Update 2004 to change the conclusion that there is inadequate or insufficient evidence to determine whether an association exists between exposure to herbicides and hepatobiliary cancer. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and hepatobiliary cancer outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Oral, Nasal, and Pharyngeal Cancer Oral, nasal, and pharyngeal cancers are relatively rare in the United States and thus difficult to study epidemiologically. Reported risk factors for nasal cancer include occupational exposure to nickel and chromium compounds, wood dust, and formaldehyde. Studies reported associations with the consumption of salt-preserved foods, cigarette smoking, and Epstein-Barr virus. NAS noted in VAO and subsequent reports that there was inadequate or insufficient evidence to determine whether an association exists between herbicide exposure and oral, nasal, and pharyngeal cancer. An occupational study by Swaen *et al.*
(2004)examined cancer mortality in herbicide appliers in the Netherlands. No deaths from nasal, oral, or pharynx cancers were observed in that cohort. In a Vietnam-veteran study, cancers of the cavity between the jaw and cheek were examined in Operation Ranch Hand veterans who were involved in the aerial spraying of herbicides. No significant difference was reported between Ranch Hand veterans and a comparison group of veterans who did not spray herbicides. (Akhtar *et al.* , 2004). NAS found there was no information contained in the research reviewed for Update 2004 to change the conclusion that there is inadequate or insufficient evidence to determine whether an association exists between exposure to herbicides and oral, nasal, and pharyngeal cancer. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and oral, nasal, and pharyngeal cancers outweighs the credible evidence for such an association, and has determined that a positive association does not exist. Bone and Joint Cancer Primary bone cancers are among the least common malignancies. The bones are a frequent site of secondary tumors of other cancers that have metastasized. NAS studied only primary bone cancer in Update 2004. Bone cancer is most common among teenagers, and is very rare among people in the age groups of most Vietnam veterans. Among the risk factors for adults are exposure to ionizing radiation from treatment for other cancers and a history of certain non-cancerous bone diseases. NAS found in VAO and subsequent reports that there is inadequate or insufficient information to determine whether an association exists between exposure to herbicides and bone and joint cancer. NAS reviewed one occupational study that examined cancer mortality in 1,341 licensed herbicide appliers in the Netherlands. No deaths from bone cancers were observed. (Swaen *et al.* , 2004.) No other relevant environmental or Vietnam-veteran studies were published since Update 2002. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and bone and joint cancer outweighs the credible evidence for such an association, and has determined that a positive association does not exist. Skin Cancers—Melanoma, Basal, and Squamous Cell NAS noted in VAO and subsequent reports that there was inadequate or insufficient information to determine whether an association exists between exposure to herbicides and skin cancer. NAS examined two categories of skin cancer: melanoma and nonmelanoma (basal-cell and squamous-cell). Melanomas occur more frequently in fair-skinned people. Incidence also increases with age, though more so in males than in females. Other risk factors can include moles on the skin, suppressed immune system, and excessive exposure to ultraviolet radiation, usually from the sun. Family history of melanoma is also a risk factor, though it is unclear whether that is the result of genetic factors or attributable to similarities in skin type and sun exposure. NAS reviewed an occupational study conducted on licensed herbicide applicators in the Netherlands. No data was available on any risk factor for skin cancer, other than age. Five deaths from skin cancer were recorded for the cohort of 1,341 people. Only 1.4 deaths would be expected. (Swaen *et al.* , 2004). NAS noted that a significant limitation of this study was its inability to discern whether, or to what extent, the increased incidence of skin cancer was attributable to herbicide exposure rather than to exposure to UV radiation, which is a significant and well-known risk factor for skin cancer. NAS concluded that herbicide applicators are likely to have had significant exposure to UV radiation, but that limitations of the study design made it impossible to separate the effect of the two occupational exposures. No environmental studies of melanoma have been published since Update 2002. In 2004, a study on the incidence of cancer in Operation Ranch Hand veterans compared with both a group of Air Force veterans not involved in herbicide spraying and a sample of the general population, showed that melanoma was more common among the Ranch Hand veterans and the Air Force veterans than in the general population. NAS noted significant limitations concerning the comparison with the general population, including the lack of control for the confounding factor of sun exposure and the possibility that rates of detection among the study population may be higher than the general population due to the heightened detection methods employed in the study. In the analyses limited to Ranch Hand and comparison Air Force veterans, the associations with melanoma were restricted to the stratum of veterans with no more than 2 years of service in Southeast Asia and to a stratum created by the subset of Ranch Hand veterans who served only in Vietnam and comparison veterans who served elsewhere in Southeast Asia. NAS found that no satisfactory rationale was given to support why the analysis was limited to veterans with less than 2 years of service or to a definition that confounds Ranch Hand status with service in Vietnam. NAS stated that, if the classifications employed in the study somehow captured a confounding factor, the proper analysis would have been to combine information from each stratum (more than 2 years of service and 2 years or less) to produce an adjusted relative risk. In view of these limitations, NAS decided that the overall association between exposure to herbicides and the incidence of melanoma in this study was not definitive. (Akhtar *et al.* , 2004). NAS concluded that there is inadequate or insufficient evidence to determine an association between exposure to herbicides and melanoma. Although some recent studies reported findings suggestive of an association, the weight of those findings is limited by the methodological concerns discussed in the NAS report. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and melanoma outweighs the credible evidence for such an association, and has determined that a positive association does not exist. Excessive exposure to ultraviolet radiation is the most important risk factor for non-melanocytic skin cancer, though some skin diseases and exposure to chemicals such as inorganic arsenic have also been identified as possible risk factors. NAS noted in VAO and subsequent updates that there was inadequate or insufficient information to determine an association between exposure to herbicides and basal-cell or squamous-cell cancers. There were no relevant environmental or Vietnam-veteran studies published regarding basal-cell and squamous-cell (non melanoma) skin cancers. NAS concluded that there is no information contained in the research reviewed for Update 2004 to change the conclusion that there is inadequate or insufficient evidence to determine whether an association exists between exposure to herbicides and basal-cell and squamous-cell skin cancers. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and basal-cell and squamous-cell skin cancers outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Breast Cancer NAS noted that breast cancer is the second most common cancer among women in the U.S. Breast cancer incidence generally increases with age. Risk factors other than aging include a personal or family history of breast cancer and certain reproductive characteristics; specifically, early onset of menarche, late onset of menopause, and either no pregnancies or first full-term pregnancy after age 30. NAS noted in VAO and subsequent reports that there is inadequate or insufficient information to determine whether an association exists between exposure to herbicides and breast cancer. No studies published since Update 2002 have investigated breast cancer. Previously published studies support the conclusion that the evidence is inadequate or insufficient to determine an association between exposure to herbicides and breast cancer. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and breast cancer outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Female Reproductive Cancer (cervix, uterus, ovary) NAS noted that the cancers of the female reproductive system include cancers of the cervix, endometrium (also referred to as the corpus uteri), and ovaries. Cervical cancers occur more often in African-American women than in white women, whereas white women are more likely to develop endometrial and ovarian cancers. The incidence of endometrial and ovarian cancer also depends on age, with older women at greater risk. Human papillomavirus infection is the most important risk factor for cervical cancer. Diet, a family history of the disease, and breast cancer are among the risk factors for endometrial and ovarian cancers. NAS noted in VAO and subsequent reports that there is inadequate or insufficient information to determine whether an association exists between exposure to herbicides and cancers of the female reproductive system. No studies published since Update 2002 have investigated cancers of the female reproductive system. NAS concluded that there is inadequate or insufficient information to determine an association between exposure to herbicides and female reproductive cancers. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and cancers of the female reproductive system outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Testicular Cancer Testicular cancer is far more likely in men younger than 40 than in men over the age of 40. Cryptorchidism, or undescended testes, is a major risk factor for testicular cancer. Family history of the disease also appears to be a risk factor for testicular cancer. NAS noted in VAO and subsequent reports that there was inadequate or insufficient information to determine whether an association exists between exposure to herbicides and testicular cancer. No relevant occupational, environmental, or Vietnam-veteran studies have been published since Update 2002. NAS concluded that there is inadequate or insufficient evidence to determine an association between exposure to herbicides and testicular cancer. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and testicular cancer outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Urinary Bladder Cancer Urinary bladder cancer is the most common of the urinary tract cancers. Bladder cancer incidence increases greatly with age over 40 years. The most important known risk factor for bladder cancer is smoking. Occupational exposures to aromatic amines (also called arylamines), polycyclic aromatic hydrocarbons (PAHs), and certain other organic chemicals used in the rubber, leather, textile, paint products, and printing industries are also associated with higher incidence of bladder cancer. High-fat diets have been implicated as risk factors, along with exposure to the parasite Schistosoma haematobium. Exposure to inorganic arsenic is also a risk factor for bladder cancer, and cacodylic acid is a metabolite of inorganic arsenic. The data remain insufficient to conclude that studies of inorganic arsenic exposure are directly relevant to exposure to cacodylic acid. Therefore, NAS did not consider the literature on inorganic arsenic. A study of the incidence of urinary bladder cancer in Vietnam veterans who participated in Operation Ranch Hand was published in 2004. The study found no significant difference between the expected and observed incidence of urinary bladder cancer. (Akhtar *et al.* , 2004). NAS noted in VAO and Update 1996 that there was limited or suggestive evidence of no association between exposure to herbicides used in Vietnam or the contaminant dioxin and urinary bladder cancer. Update 1998 provided additional information that led NAS to change its conclusion to inadequate or insufficient information regarding an association with urinary bladder cancer. No relevant occupational or environmental studies regarding urinary bladder cancer have been published since Update 2002. The new evidence presented by Akhtar *et al.* ,
(2004)did not change the committee's previous findings, which placed urinary bladder cancer in the inadequate or insufficient category. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and urinary bladder cancer outweighs the credible evidence for such an association, and has determined that a positive association does not exist. Renal Cancer Renal cancer is twice as common in men as in women. With the exception of Wilms' tumor, which is more likely to appear in children, renal cancer is more common in individuals over age 50. Smoking is a risk factor for renal cancer. Other potential risk factors include diet, weight, and occupational exposure to asbestos, cadmium, and organic solvents. Some people with rare syndromes such as von Hippel-Lindau syndrome and tuberous sclerosis are at higher risk. Firefighters who are exposed to pyrolysis products are also in a known higher-risk group. NAS noted in VAO and subsequent reports that there was inadequate or insufficient information to determine whether an association exists between exposure to herbicides and renal cancer. In 2004, Swaen *et al.* , published the results on a total of 21 years of follow-up on the mortality experience of an established cohort of 1,341 licensed herbicide appliers in the Netherlands. (Swaen *et al.* , 2004). Four deaths from kidney cancer were reported, and only three were expected. Due to the relatively small study size and lack of exposure information, NAS did not find this study to be sufficiently suggestive of an association. No relevant environmental or Vietnam-veteran studies have been published since Update 2002. On the basis of its evaluation of the epidemiologic evidence reviewed and in previous VAO reports, NAS concluded that there is inadequate or insufficient evidence to determine an association between exposure to herbicides and renal cancer. Taking account of the available evidence and NAS' analysis, the Secretary has found the credible evidence against an association between herbicide exposure and renal cancer outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Leukemia (Other Than Chronic Lymphocytic Leukemia (CLL)) There are four primary types of leukemia: the acute and chronic forms of lymphocytic leukemia and the acute and chronic forms of myeloid (or granulocytic) leukemia. Acute lymphocytic leukemia
(ALL)is a disease of the young and of individuals older than 70, and plays a small role in the age groups that characterize most Vietnam veterans. Exposure to high doses of ionizing radiation is a known risk factor. Acute myeloid leukemia
(AML)is the most common leukemia among adults. Risk factors for AML include high doses of ionizing radiation, occupational exposure to benzene, and some medications used in cancer chemotherapy. Genetic disorders including Fanconi's anemia and Down's syndrome are associated with an increased risk for AML. Tobacco smoking has also been suggested as a risk factor. The incidence of chronic myeloid leukemia
(CML)increases with age for individuals over 30. For individuals in the age groups that characterize most Vietnam veterans, CML accounts for about one in five leukemias. CML is associated with an acquired chromosomal abnormality known as the “Philadelphia chromosome.” Exposure to high doses of ionizing radiation is a known risk factor for that abnormality. NAS noted in VAO and subsequent reports that there is inadequate or insufficient information to determine whether an association exists between exposure to herbicides and leukemia. In Update 2004, NAS reviewed two relevant occupational studies. A study of 1,341 licensed herbicide appliers in the Netherlands showed that three deaths from all leukemias were reported when 2.2 deaths were expected. (Swaen *et al.* , 2004). An occupational population-based, case-control study conducted in 11 agricultural and industrial areas of Italy showed an increased risk of leukemia based on exposure to phenoxy herbicides. (Miligi *et al.* 2003.) NAS noted that the small number of cases and other limitations prevented adequate analysis of the increased risk based on the study data. No environmental studies have been published since those reviewed in Update 2002. A study of Operation Ranch Hand veterans and a cohort of other Air Force veterans who were not involved in the spraying of herbicides was published in 2004. In this study, all leukemias were combined with multiple myeloma and the lymphomas to form the category of lymphopoietic cancers. No excess of such cancers was reported in the Operation Ranch Hand veterans. These results did not change when the analyses were restricted to veterans whose tours of duty ended between 1966 and 1970, the years when Agent Orange was the predominant herbicide in use in Vietnam. (Akhtar *et al.* , 2004). On the basis of its evaluation of the epidemiologic evidence reviewed and in previous VAO reports, NAS concluded that there was inadequate or insufficient evidence to determine an association between exposure to herbicides and leukemias other than CLL. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and leukemia (other than CLL) outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Abnormal Sperm Characteristics and Infertility NAS noted in VAO and subsequent reports that there is inadequate or insufficient information to determine whether an association exists between exposure to herbicides and altered sperm parameters or infertility. A study examined factors possibly associated with infertility in a group of women living in an agricultural region of Wisconsin. For the study, a woman was considered infertile if she had 12 months of unprotected intercourse without conceiving a pregnancy that ended in live birth. Nine case subjects and 11 control subjects reported being exposed to 2,4,5-T and four case subjects and four control subjects reported being exposed to 2,4-D. This study was limited because the sample sizes were small presenting an inability to examine the effects of specific herbicides. Moreover, information on risk factors were obtained from self-reports, which can be subject to recall bias. (Greenlee *et al.* , 2003). A study examined whether previously poor semen quality in men from rural and urban areas was attributable to use of pesticides including herbicides, fungicides, and other substances. None of the subjects from Minnesota had detectable 2,4-D metabolites in their urine. The subjects from Missouri had 2,4-D metabolite levels that were only of borderline statistical significance. The study showed that 2,4-D was not associated with sperm mobility or concentration, but showed a weak association with sperm morphology. (Swaen *et al.* , 2003). A study was conducted to determine whether there was an association between TCDD exposures and the menstrual characteristics of women exposed to it for the next 20 years. The study used women who lived near the site of an industrial explosion in 1976 at Seveso, Italy. The main conclusion from the study was that serum TCDD concentration was associated with some menstrual cycle characteristics, with possible effect modification by menarchial status. (Eskenazi *et al.* , 2002). No relevant Vietnam-veteran studies have been published since Update 2002. NAS concluded that there is inadequate or insufficient evidence to determine an association between exposure to herbicides and infertility, subfertility, sperm quality or count, or altered hormone concentrations. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and infertility and sperm abnormalities in veterans outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Spontaneous Abortion Spontaneous abortion is the expulsion of a nonviable fetus, usually before 20 weeks of gestation. The background risk of a spontaneous abortion is generally 7-15%, but this does not include the many more pregnancies that terminate before the woman becomes aware of the pregnancy. NAS concluded in VAO and subsequent updates that there was inadequate or insufficient information to determine an association between exposure to herbicides and spontaneous abortion. No relevant occupational or Vietnam-veteran studies have been published since Update 2002. Eskenazi *et al.*
(2003)evaluated data from the Seveso Women's Health Study of women who lived near the site of an industrial explosion in 1976 at Seveso, Italy for an association between individual serum TCDD concentrations and birth outcomes in women who resided near the accident. No association was revealed by the Eskenazi study. Because the spontaneous abortions were self-reported, a truly unexposed control population could not be used in the study. Therefore, it could be hypothesized that the study does not rule out the possibility of a TCDD effect during the earliest period of pregnancy. NAS concluded that there is insufficient information available to determine whether an association exists between the risk of spontaneous abortion and maternal exposure to herbicides. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and spontaneous abortion outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Neonatal or Infant Death and Stillbirth in Offspring of Exposed Individuals Stillbirth, or late fetal death, typically refers to the delivery at or after 20 weeks of gestation of a fetus that shows no signs of life. Neonatal death refers to the death of a liveborn infant within 28 days of birth. Typically, causes of stillbirth and neonatal death overlap considerably and are commonly analyzed together in a category called perinatal mortality. The most common causes of perinatal mortality among low-birthweight liveborn and stillborn infants are placental and delivery complications. Among infants weighing more than 2,500 grams at birth, the most common causes are complications of the cord, placenta, and membranes and lethal congenital malformations. (Kallen, 1988). NAS concluded in VAO and subsequent updates that there was inadequate or insufficient information to determine an association between exposures to herbicides and stillbirth, neonatal death, or infant death. No relevant occupational, environmental, or Vietnam-veteran studies have been published since Update 2002. NAS concluded that there is inadequate or insufficient evidence to determine an association between exposure to herbicides and stillbirth, neonatal death, or infant death in offspring of exposed individuals. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and stillbirth, neonatal death, and infant death in offspring of exposed individuals outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Low Birthweight in Offspring of Exposed Individuals The World Health Organization
(WHO)recommends 2,500 grams as the threshold determination for low birthweight. Low birthweight is among the important predictors of neonatal mortality and morbidity, and preterm delivery is a significant cause. Factors most strongly associated with reduced birthweight are maternal tobacco use during pregnancy, multiple births, and race or ethnicity. Other potential risk factors are socioeconomic status, maternal weight, birth order, maternal complications during pregnancy, and obstetric history. Established risk factors for preterm delivery include race, marital status, low socioeconomic status, tobacco use, and cervical, uterine, or placental abnormalities. (Berkowitz and Papiernik, 1993). A case-control study examined birthweight in the offspring of women who were involved in farming for seven
(7)or more days during their pregnancies. In total, the study included 117 women who delivered low birthweight infants (cases) and 377 women who delivered infants weighing at least 2,500 grams (controls). No significant differences were exhibited in the birthweights in the exposed and non-exposed groups. Pregnancy duration was also the same time, with a mean of 38 weeks in cases and controls. NAS determined the study was limited by its retrospective nature. (Dabrowski *et al.* , 2003). An environmental study examined the association between TCDD exposure and reproductive outcomes among 510 women exposed to TCDD who had complete pregnancies within 20 years of their exposure. The study showed a small non-significant association between maternal dioxin concentrations and decreased birthweight and prematurity. NAS determined that there were flaws in the study, such as the fact that information was obtained by self-report, and that there was no control group or a measurement of background dioxin. (Eskenazi *et al.* , 2003). No relevant Vietnam-veteran studies were published since Update 2002. NAS concluded that there is inadequate or insufficient evidence to determine an association between exposure to herbicides and low birthweight and preterm delivery in offspring of exposed individuals. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and low birthweight and preterm delivery in offspring of exposed individuals outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Birth Defects (Other Than Spina Bifida) in Offspring of Exposed Individuals The March of Dimes defines a birth defect as “an abnormality of structure, function, or metabolism, whether genetically determined or as a result of an environmental influence during embryonic or fetal life.” (Bloom, 1981). Major birth defects, which occur in 2-3% of live births, are severe enough to interfere with viability or physical well-being. Birth defects are detected in another 5% of babies through their first year of life. The causes of most birth defects are unknown. Known causes include genetic factors, exposure to some medications, environmental contaminants, occupational hazards, and lifestyle factors. In 1994, NAS found in VAO that there was inadequate or insufficient information to determine an association between exposure to herbicides and birth defects among offspring. But in Update 1996 and subsequent studies, NAS concluded that there was limited or suggestive evidence of an association between at least one of the compounds of interest and spina bifida in the children of exposed veterans. There was no change in the conclusions about other birth defects. An environmental study examined the impact of exposure to emissions from municipal solid waste incinerators on birth defects in a region of France over a ten-year period. Congenital anomalies were not significantly associated with exposure overall, but some specific anomalies (facial clefts, renal dysplasia, obstructive uropathies, cardiac anomalies) showed significant dose-response relationships. The exposure indicator in this study could not differentiate exposure to dioxins from exposure to metals. (Cordier *et al.* , 2004). An ecologic study compared rates of adverse birth outcomes in U.S. agricultural states. The use of herbicides on the fields during the times when certain babies were conceived showed a possible increased risk for some defects, such as musculoskeletal and integumental anomalies. However, this study did not directly measure herbicide exposure; instead, it measured by acreage. (Schreinemachers, 2003). No relevant occupational studies have been published since Update 2002. Data from the Centers for Disease Control and Prevention
(CDC)regarding birth defects in the past 25 years showed that there was no greater risk among Vietnam veterans for fathering babies with serious birth defects. (Correa-Villasenor *et al.* , 2003). Excluding spina bifida, NAS concludes that there is inadequate or insufficient evidence to determine an association between exposure to herbicides and all other birth defects in offspring of exposed individuals. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and all other birth defects other than spina bifida outweighs the credible evidence for such an association and he has determined that a positive association does not exist. Childhood Cancer (Including Acute Myelogenous Leukemia) in Offspring of Exposed Individuals Cancer remains the leading cause of death from disease in children under the age of 15. Leukemia is the most common cancer in children. The second most common group of cancers in children is that of the central nervous system. NAS concluded in VAO and subsequent studies that there was inadequate or insufficient information to determine an association between exposure to herbicides and childhood cancers. An agricultural health study examined childhood cancer in the offspring of male pesticide applicators in Iowa. Incidence was compared with the Iowa Surveillance, Epidemiology and End Result data. Potential associations between pesticide exposure and individual types of cancer were not examined. There was a higher rate of childhood cancers for paternal exposure to herbicides than for maternal exposure. (Flower *et al.* , 2004). No relevant environmental or Vietnam-veteran studies have been published since Update 2002. The only new study reviewed for this update (Flower *et al.* , 2004), did not show any significant association between the relevant exposures and childhood cancer in offspring of exposed individuals. On the basis of its evaluation of the epidemiologic evidence reviewed here and in previous VAO reports, NAS concluded that there is inadequate or insufficient evidence to determine an association between exposure to herbicides and childhood cancer in offspring of exposed individuals. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and childhood cancer in offspring of exposed individuals outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Neurobehavioral Disorders (Cognitive or Neuropsychiatric) NAS noted in VAO and subsequent reports that there was inadequate or insufficient information to determine whether an association exists between exposure to herbicides and cognitive and neuropsychiatric effects. Since Update 2002, five reports have investigated associations between neurobehavioral disorders and possible exposure to herbicides. The five reports are:
(1)An update of the Air Force Health Study
(AFHS)(Barrett *et al.* , 2003),
(2)a cross-sectional study of a cohort of Korean veterans who served in Vietnam (Kim *et al.* , 2003),
(3)an update of an occupational cohort from the Czech Republic (Pelclova *et al.* , 2002),
(4)a cohort study from the Bordeaux region of France (Baldi *et al.* , 2003) and
(5)a semi-ecological study from a community adjacent to a wood treatment plant (Dahlgren *et al.* , 2003). Psychological functioning was compared in Ranch Hand veterans and other Vietnam veterans (Barrett *et al.* , 2003). The characteristics of the study groups indicated that those with high exposure were more likely to be younger enlisted personnel; those with background or low exposure were older officers. Two standard psychological test instruments were administered: The Minnesota Multiphasic Personality Inventory
(MMPI)and the Millon Clinical Multiaxial Inventory (MCMI). MMPI results were inconsistent and showed no significant associations with exposure. The conclusions from the studies were limited by the possibility of misclassification of exposure, selection bias, and uncontrolled confounding. The authors concluded that there were few consistent differences in psychological functioning between groups based on serum dioxin concentrations. A study published results of a cross-sectional study of Korean veterans who served in Vietnam. Health outcomes were assessed by a group of four family practitioners, blinded to subjects' exposure status, using a “standardized comprehensive clinical investigation.” There was a significantly higher prevalence of post-traumatic stress disorder
(PTSD)and mood disorder in Vietnam veterans than in the non-Vietnam comparison group; although the association was not significant after controlling for multiple potential confounders, and it did not differ by exposure in Vietnam veterans. The study was limited because of the possibility of selection bias and a chance of residual confounding because of the demographic difference between groups. (Kim *et al.* , 2003). The Bordeaux study (Baldi *et al.* , 2003) examined a cohort of 2,792 persons over age 65, enrolled in 1987 for the purposes of studying normal and pathological cerebral aging and loss of independence in the elderly. Exposures were categorized into quartiles by the likelihood of occupational use of chemical pesticides on the basis of self-reports, which introduced the possibility of recall bias. The high drop-out rate raises concerns of selection bias. The authors of the study could not identify exposure to specific compounds. The study offered no evidence that would implicate the compounds of interest because the exposures were not comparable to herbicide exposures in Vietnam. Dahlgren *et al.* used a semi-ecological design to assess the possibility that self-reported symptoms suggesting neurobehavioral disorders in a group of people from eastern Mississippi were related to residence near a creosote treatment plant. (Dahlgren *et al.* , 2003). The study suffered from design weaknesses, including selection and ascertainment bias, lack of objective exposure data, and lack of physician-confirmed diagnoses. NAS concluded that there is no consistent evidence for any association between neurobehavioral disorders and herbicide exposure. On the basis of its evaluation of the epidemiological evidence reviewed here and on previous VAO reports, NAS concludes that there is still inadequate or insufficient evidence to determine whether an association exists between exposure to herbicides and neurobehavioral disorders (cognitive or neuropsychiatric). Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and neurobehavioral disorders (cognitive or neuropsychiatric) outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Movement Disorders, Including Parkinson's Disease
(PD)and Amyotrophic Lateral Sclerosis
(ALS)• Parkinson's Disease Parkinson's Disease
(PD)is a progressive neurodegenerative disorder that affects millions of people worldwide. Its primary clinical manifestations are bradykinesia, resting tremor, cogwheel rigidity, and gait instability. These signs were first described in 1817 as a single entity by James Parkinson, who believed that severe fright from a traumatic experience was a probable cause. Because of the increasing concern that a link exists between PD and various chemicals used in herbicides, NAS, in VAO and subsequent reports, suggested that as Vietnam veterans move into the age groups when PD is more prevalent, attention be given to the frequency and character of new cases of PD in exposed versus non-exposed individuals. In the Bordeaux cohort study, new cases at the 8- and 10-year follow-up were identified by self-report in response to the question, “Do you have Parkinson's disease?” The incidence for exposed and unexposed subjects, respectively, was estimated at 8.9 and 4.1 cases per 1,000 person-years. The results do suggest increased risk to men with occupational exposure to pesticides, but the use of fungicides in vineyards predominated, rather than any of the compounds of interest. The case-control study from Bordeaux compared 84 subjects over age 70 with PD who had been recruited from hospital-based specialty clinic practices with a control group of 252 subjects without PD, identified from the previously described cohort. There is no evidence from that study to implicate herbicides to Vietnam veterans. (Baldi *et al.* , 2003). On the basis of its evaluation of the epidemiologic evidence reviewed here and in previous VAO reports, NAS concluded that there is inadequate or insufficient information to determine whether an association exists between exposure to herbicides and PD. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and PD outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. • Amyotrophic Lateral Sclerosis
(ALS)ALS is a progressive motor neuron disease with adult onset that presents with muscle atrophy, weaknesses, and fasciculations. The incidence of ALS peaks between the ages of 55 to 75 years. Known risk factors for ALS are age and a family history of ALS. Interest in the role of occupational or environmental exposure originated in cases of motor neuron disease associated with exposure to heavy metals, chemical plants, animal carcasses, heavy manual labor, work with electricity, pneumatic tools, work in the plastic industry, and work as a truck driver. No relevant epidemiologic studies have been published since Update 2002. On the basis of its evaluation of the epidemiologic evidence reviewed here and in previous VAO reports, NAS concluded that there is inadequate or insufficient evidence of an association between exposure to herbicides and motor neuron disease or ALS. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and ALS outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Chronic Peripheral Nervous System Disorders Peripheral neuropathy consists of disorders of the peripheral nervous system. Manifestations of this syndrome can include a combination of sensory changes, motor weakness, or autonomic instability. NAS noted in VAO and subsequent reports that there was inadequate or insufficient evidence of an association between exposure to herbicides and peripheral neuropathy. Peripheral neuropathy was one outcome considered in a study of Korean Vietnam veterans (Kim *et al.* , 2003). It was significantly more common in Vietnam veterans than in non-Vietnam veterans, with a 2.4-fold risk even after controlling for alcohol use and age, although there were no differences based on estimated TCDD exposure within subgroups of Vietnam veterans. Diabetes was also more common in Vietnam veterans. The authors of the study concluded that there was an excess frequency of peripheral neuropathy in Vietnam veterans. The report distinguishes between “peripheral neuropathy” and “neuropathy with diabetes,” which was not significantly different between the groups. The possibility of selection bias was a concern in this study, only 28% of eligible Vietnam veterans participated in the study and participation may have been related to health status. Therefore, the study provides some evidence of an association between service in Vietnam and peripheral neuropathy. However, the study does not provide evidence for an association between specific exposure to the compounds of interest and chronic persistent neuropathy. NAS concluded that there remains inadequate or insufficient evidence of an association between exposure to herbicides and chronic persistent peripheral neuropathy. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and chronic persistent peripheral neuropathy outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Respiratory Disorders Non-malignant respiratory disorders comprise acute and chronic lung diseases other than Cancer. Acute respiratory disorders include pneumonia and other respiratory infections. Those disorders can be increased in frequency and severity when the normal defense mechanisms of the lower respiratory tract are compromised. The major risk factor for many non-malignant respiratory disorders is cigarette smoking. Cigarette smoking is the major cause of many airway disorders, and makes almost every respiratory disorder more severe and symptomatic than would otherwise be the case. Vietnam veterans are reported to smoke more heavily than are non-Vietnam veterans (McKinney *et al.* , 1997). NAS noted in VAO and subsequent updates that there was inadequate or insufficient information to determine an association between exposure to herbicides and respiratory disorders. A cross-sectional environmental study used questionnaires to gather information on potential adverse health effects among residents near a wood treatment plant. Exposed residents reported greater frequency of chronic bronchitis by history and asthma by history. Selection bias and recall bias limit the utility of the results. It is unclear whether the authors adequately controlled for history of tobacco use. In addition, multiple environmental exposures occurred in the neighborhood near the plant, and the authors could not determine which exposures were responsible for the reported adverse health effects. (Dahlgren *et al.* , 2003). No relevant occupational or Vietnam-veteran studies have been published since Update 2002. No new studies provide evidence of a direct risk of non-malignant respiratory disorders in adults since those reviewed in Update 2002. On the basis of its evaluation of the epidemiologic evidence reviewed in Update 2004 and in previous VAO reports, NAS concluded that there is inadequate or insufficient evidence to determine an association between exposure to herbicides and non-malignant acute or chronic respiratory disorders. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and respiratory disorders outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Gastrointestinal, Metabolic, and Digestive Disorders (Changes in Liver Enzymes, Lipid Abnormalities, Ulcers) Gastrointestinal and digestive disease includes diseases of the esophagus, stomach, intestines, rectum, liver, and pancreas. The two conditions most often discussed in the literature reviewed are peptic ulcer disease and liver disease. The symptoms and signs of gastro intestinal disease and liver toxicity are highly varied and often vague. The most convenient way to categorize diseases that affect the gastrointestinal system is by the affected anatomic segment. NAS in VAO and subsequent reports found there was inadequate or insufficient information to determine whether an association exists between exposure to herbicides and gastrointestinal and digestive disease, including liver toxicity. No relevant environmental or Vietnam-veteran studies have been published since Update 2002. NAS concluded that there was no information contained in the research reviewed for Update 2004 to change the conclusion that there is inadequate or insufficient evidence to determine whether an association exists between exposure to herbicides and gastrointestinal and digestive diseases. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and gastrointestinal and digestive disease outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Plasma lipid (notably cholesterol) concentrations have been shown to predict cardiovascular disease and are considered fundamental to the underlying atherosclerotic process. The two major types of lipids, cholesterol and triglycerides, are carried in the blood attached to proteins to form lipoproteins. NAS in VAO and subsequent reports found there was inadequate or insufficient information to determine whether an association exists between exposure to herbicides and lipid and lipoprotein disorders. No relevant environmental or Vietnam-veteran studies of lipid and lipoprotein disorders have been published since those reviewed in Update 2002. An occupational study conducted measured cholesterol and triglyceride concentrations in 12 men who were exposed to extremely high concentrations of TCDD in the late 1960s while they were employed in herbicide production at a chemical factory in the former Czechoslovakia. The correlation between TCDD in 1996 and highest recorded measurement of triglyceride or cholesterol at any point between 1968 and 2001 was 0.66 for triglyceride and 0.78 for cholesterol. No information was given about follow up measures of lipids collected in standard or periodic fashion for participants and there is no discussion of how individual differences in treatment of elevated cholesterol could influence the highest recorded value for total cholesterol. (Pelclová *et al.* , 2002). Hu *et al.*
(2003)conducted a cross-sectional study of dioxin-furan exposures and lipids in workers at municipal-waste incinerator plants in Taipei City, Taiwan. A total of 133 workers were randomly sampled from 3 plants; the workers had to have been employed for at least 6 months in the operation and control or maintenance departments. Seventeen
(17)cogeners were measured, including TCDD. Workers with TCDD above the median had higher average cholesterol and were more likely to have cholesterol above 220 mg/dL. The relationship between TCDD and cholesterol was not statistically significant when TCDD was measured by tertiles, quartiles, or as a continuous variable. TCDD was not associated with triglyceride as a continuous or categorical measure. The study by Pelclová *et al.* has some shortcomings, including the small sample (12 men). The study by Hu *et al.* successfully recruited a cross-section of workers and did show significant variation in cholesterol by a dichotomous measure of TCDD. The loss of statistical significance with more detailed categories or along the full continuum of TCDD values suggests that the findings from the initial analysis are not robust or consistent. Several individual cogeners other than TCDD were identified as statistically significant correlates of elevated cholesterol. The study did not allow for isolation of the effect of any single exposure. The relationship between herbicide exposure and lipid remains uncertain. NAS concluded that there is inadequate or insufficient evidence to determine whether an association exists between exposure to herbicides and lipid and lipoprotein disorders. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and lipid and lipoprotein disorders outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Immune System Disorders (Immune Suppression, Autoimmunity) The immune system defends the body against infection by viruses, bacteria, and other disease-producing microoganisms (pathogens). The immune system's cells arise from stem cells in the bone marrow; they are found throughout the body's lymphoid tissues, and they circulate in the blood as white blood cells. The immune system also operates in cancer surveillance, destroying cells that have transformed and might otherwise develop into tumors. Autoimmune disease is an example of the immune system's causing rather than preventing disease. In this case, the immune system mistakenly attacks the body's own cells and tissues as if they were foreign. In new studies from Seveso, Italy, plasma immunoglobulin
(Ig)and complement concentrations were measured in a random sample of the population. This was conducted in highly exposed zones and in the surrounding uncontaminated areas. The concentrations of one plasma immunoglobulin (IgG), significantly decreased with increasing TCDD concentration. The association was present after adjusting for age, sex, tobacco use, and computation of domestic livestock and poultry. (Baccarelli *et al.* , 2002). Two studies have evaluated the influence of exposure to TCDD-like compounds on immune response in children. One study characterized the immune status of adolescent boys and girls in Flanders, Belgium, in relation to their blood concentrations of PCBs and dioxin like compounds. The results found in the adolescents might suggest a dioxin-induced suppression of the immune response, consistent with the findings in the laboratory animals exposed to TCDD. (Van Den Heuvel *et al.* , 2002). In a follow up study of 8 year-old Dutch children perinatally exposed to dioxin, researchers found a decrease in allergy in relation to increasing dioxin exposure. The study found an increased percentage of nai ve versus activated T cells, which is consistent with a generalized decrease in immune responsiveness associated with dioxin exposure. (Tusscher *et al.* 2003). One study examined Korean Vietnam War veterans for evidence of immune system changes in relation to their operation in various areas of Vietnam. A significant increase in plasma IgE was found in both groups of veterans compared with control subjects. The patient group also had significantly decreased plasma IgG1. Those changes correlated with decreased production of interferon gamma in the patient group and with increased production of interleukin 4 in both veterans' groups when the T cells from the subjects were cultured in vitro. No changes in the plasma concentrations of antibodies against double-stranded DNA or extractable nuclear antigens, both markers of autoimmune disease, were found in the veterans, nor were changes found in frequency distribution of peripheral blood leukocyte subpopulations. (Kim H-A *et al.* , 2003). TCDD is a well known immunosuppressive agent in laboratory animals; it is among the most potent immunotoxicants in the environment. Therefore, one would expect that exposure of humans to sufficiently high doses of TCDD would result in immune suppression. However, several studies of various parameters of human immune function have failed to reveal consistent correlations with TCDD exposure, and no detectable pattern of increased infectious diseases has developed in veterans exposed to high concentrations of TCDD or other herbicides used in Vietnam. Although suppression of the immune response by TCDD could increase the risk of some cancers in Vietnam veterans, there is no evidence to support that connection. Studies that examined the influence of TCDD on IgE production have generated additional conflicting data. Two studies revealed a significant reduction in IgE production and associated allergic responses correlated with increasing exposure to TCDD and related compounds among children in Belgium and the Netherlands (Tusscher *et al.* , 2003; Van Den Heuvel *et al.* , 2002). In contrast, Korean Vietnam veterans had increased rather than decreased IgE concentrations in plasma—independent of health status. (Kim H-A *et al.* , 2003). No relevant occupational studies were published since those reviewed in Update 2002. NAS noted in VAO and subsequent reports that there was inadequate or insufficient information to determine whether an association exists between exposure to herbicides and immune system disorders. NAS concluded that there was no information reviewed for Update 2004 to change the conclusion that there is inadequate or insufficient evidence to determine whether an association exists between exposure to herbicides and immune system disorders. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between immune system disorders and herbicide exposure outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Circulatory Disorders The term circulatory disorder includes hypertension, heart failure, arteriosclerotic heart disease, peripheral vascular disease, and cerebrovascular disease. NAS noted in VAO and subsequent reports that there was inadequate or insufficient information to determine whether an association exists between exposure to herbicides and circulatory disorders. An occupational study presented results for a 21-year-old follow up of mortality in a cohort of 1,341 licensed herbicide applicators working for government agencies in the Netherlands. The workers had relatively low cardiovascular mortality. (Swaen *et al.* , 2004). An ecological study reported no association between measure of dioxin emissions and cardiovascular or cerebrovascular mortality after adjustment for socioeconomic correlates of dioxin emissions. However, the study design precludes inferences about the relationship between exposure and disease among individuals. This study cannot be interpreted as important evidence of no association. (Fukuda *et al.* , 2003). A Vietnam-veteran study reported the results of a cross-sectional study of exposure to Agent Orange and the prevalence of large number of health outcomes in Korean veterans who had served in Vietnam. The study shows an elevated prevalence of hypertension in Vietnam veterans compared with that for veterans who served elsewhere. However, some of the weaknesses included in this study include no information on the measurement of disease, and therefore no opportunity to comment on the quality of measurement. There is also the possibility of selection bias in the formation of the study population due to a law in Korea to support medical care and compensation for herbicide victims. (Kim J-S *et al.* , 2003). The new occupational and environmental studies of circulatory conditions do not support an association for exposure to herbicides, but they also do not represent compelling evidence for the lack of an association. On the basis of its evaluation of the epidemiologic evidence reviewed here and in previous VAO reports, NAS concluded that there is no information contained in Update 2004 to change the conclusion that there is inadequate or insufficient evidence to determine whether an association exists between exposure to herbicides and specific circulatory disorders (coronary artery disease, myocardial infarction, stroke, hypertension) or circulatory conditions in general. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and circulatory disorders outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. AL Amyloidosis Amyloidosis refers to a group of related disorders that share the common feature of the deposition of insoluable, fibrous amyloid protein, mainly in the extracellular spaces of organs and tissues to a point that causes organs to malfunction. NAS reviewed AL amyloidosis (also sometimes referred to as primary amyloidosis), in which the light chain of immunoglobulin molecules is the aberrant protein. AL amyloidosis is the most common form of amyloidosis in the United States. VA identified AL amyloidosis as a concern in Update 1998. It was examined specifically by the committees responsible for Updates 2000 and 2002. In Update 2002, NAS found there was inadequate or insufficient information to determine whether an association exists between exposure to herbicides and AL amyloidosis. No relevant occupational, environmental, or Vietnam-veteran studies have been published since Update 2002. NAS concluded that there is no information to change the conclusion that there is inadequate or insufficient evidence to determine whether an association exists between exposure to herbicides and AL amyloidosis. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and amyloidosis outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Endometriosis The endometrium is the tissue that lines the inside of the uterus. In endometriosis, the endometrium is found outside the uterus, usually in other parts of the reproductive system, the abdomen, or the tissues near the reproductive organs. The tissue develops into growths or lesions that respond to hormonal changes in the body, and break down and bleed each month in concert with a woman's menstrual cycle. It results in inflammation, internal bleeding, and degeneration of blood and tissue, which can cause scarring, pain, infertility, adhesions, and intestinal problems. The exact cause of endometriosis is unknown, though genetics is a possible etiology. NAS reviewed endometriosis for the first time in Update 2002. Since Update 2002, three environmental studies have been conducted that examined the relationship between exposures to some of the compounds of interest and endometriosis. One such study investigated the development of endometriosis among participants of the Seveso Women's Health Study. The cohort consisted of women who had lived in proximity to the Seveso accident site in 1976 and had TCDD serum measurements in blood collected between 1976 and 1980. Women in the highest exposure group showed a doubling in the risk of endometriosis compared with the lowest exposure group, although the increase was not statically significant, possibly because of the small number of confirmed cases. A major limitation of the study was the inability to confirm with laparoscopy the disease state of the largest group, those with an uncertain diagnosis. No truly unexposed control group was included in the study. (Eskenazi *et al.* , 2002). The second study completed a population-based cross-sectional study of residents in several Belgian towns in the vicinity of industrial sites or municipal solid waste incinerators and a control group with no known exposures to dioxins or PCBs. There was no difference in the mean TEQ (toxicity equivalent) concentrations between the 10 cases and 132 controls. The study's usefulness is compromised because of reliance on self-reports and because of the small number of cases. (Fierens *et al.* , 2003). The third study conducted a pilot case-control study of women of reproductive age in Italy and Belgium to determine whether there is a correlation between blood concentrations of dioxin-like compounds and endometriosis. Controls were patients suspected of having a benign adnexal mass; cases were suspected of having endometriosis. The data did not indicate that the concentration of 2,3,7,8-TCDD was elevated in women with endometriosis. Overall, the study did not show that women with endometriosis had higher 2,3,7,8-TCDD or total TEQ than did controls. The study was limited in its ability to detect differences, however, by the small number of subjects. The selection criteria, which allowed all women with suspected gynecological abnormality, also introduced bias. (De Felip *et al.* , 2004). No relevant occupational or Vietnam-veteran studies have been published since Update 2002. None of the three studies demonstrated an increased risk for endometriosis with exposure to dioxin or dioxin-like compounds. NAS concluded that there is inadequate or insufficient evidence to determine whether an association exists between exposure to herbicides and endometriosis. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and endometriosis outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Effects on Thyroid Homeostasis The thyroid gland secretes hormones (T4 and T3) that stimulate metabolism. Secretion of T4 and T3 is under the control of thyroid-stimulating hormone (TSH), which is secreted by the anterior pituitary gland. The thyroid also secretes calcitonin, a hormone that controls calcium concentration in the blood and storage of calcium in bones. Chemical-induced alterations in thyroid homeostasis can adversely affect the development of many organ systems, including the nervous and reproductive systems. Most adverse effects are caused by lack of thyroid hormone alone rather than by increases in TSH. TCDD affects the concentrations of thyroid hormones; the effects appear to be species-dependent and may reflect both the dose and the duration of exposure. TCDD influences the metabolism of thyroid hormones and TSH. Studies of environmental exposure have emphasized thyroid alterations in prenatal and early childhood development rather than in adults. NAS reviewed the thyrotoxic potential of herbicides for the first time in Update 2002 and concluded that there was inadequate or insufficient information to determine an association between exposure to herbicides and adverse effects on thyroid homeostasis. An occupational study measured serum hormone and TCDD concentration in 37 men who had sprayed 2, 4,5-T. In correlation analysis, TCDD concentrations were inversely related to T3 and TSH. The association was strongest when historical, but not current, serum TCDD concentrations were considered. (Johnson *et al.* , 2001). No relevant environmental studies were published since Update 2002. A Vietnam-veterans study examined thyroid hormone status in the AFHS cohort. At each examination there was a trend toward an increasing concentration of TSH, which was not accompanied by changes in circulating T4 or in the percentage uptake of T3. Ranch Hand veterans had TSH significantly higher than did the comparison population. No changes in microsomal or antithyroid antibodies were observed, nor was there any evidence of changes in clinical thyroid disease. (Pavuk *et al.* , 2003). NAS determined the lack of data on the association between exposure to the chemicals of interest and adverse effects on thyroid homeostasis, coupled with the lack of exposure information on Vietnam veterans precludes quantification of any possible increase in their risk. NAS concluded that there is inadequate or insufficient evidence to determine whether an association exists between exposure to herbicides and adverse effects on thyroid homeostasis. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and adverse effects on thyroid homeostasis outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Gastrointestinal Tumors (Esophagus, Stomach, Pancreas, Colon, Rectum) Gastrointestinal Tract tumors are among the most common of cancers. NAS reviewed data on esophageal cancer, stomach cancer, pancreatic cancer, colon cancer, and rectal cancer. Colon cancer makes up about 40% of gastrointestinal tract cancer diagnoses and deaths. The incidence of stomach, colon, rectal, and pancreatic cancers increase with age in people 50-64 years old. In general, the incidence is higher in men than women, and is higher in blacks than in whites. Other risk factors for those cancers vary but always include family history of the same form of cancer, some diseases of the affected organ, and dietary factors. NAS noted in VAO and subsequent reports that there was limited or suggestive evidence of no association between exposure to herbicides and gastrointestinal
(GI)tract tumors. NAS examined two occupational studies. One study showed that male chemical production workers previously exposed to substantial amounts of dioxin experienced no increased risk from death from gastric cancer. (Bodner *et al.* , 2003). In another study of licensed herbicide appliers in the Netherlands, a lower than expected number of deaths due to esophagus and stomach cancer was reported. (Swaen *et al.* , 2004). An environmental study of 590 municipalities in Japan examined the relationships between indexes of dioxin emissions from incineration plants and cause-specific mortality among nearby residents. When the analysis was restricted to municipalities with incineration plants, there was a positive and statistically significant correlation in men for stomach cancer for one dioxin index and a statistically significant negative correlation for three dioxin indexes. (Fukuda *et al.* , 2003). The Vietnam-veteran study reported on cancer incidence and mortality in Air Force veterans of the Vietnam War. Index cases were Operation Ranch Hand veterans who sprayed dioxin-contaminated herbicides in Vietnam. Comparison subjects served in Southeast Asia during the same period but did not spray herbicides. The group reported that the incidence of cancer of the digestive system was significantly lower than expected, compared with national incidence rates, in white Ranch Hand veterans. There were insufficient numbers of non-white Ranch Hand veterans to make estimates. (Akhtar *et al.* , 2004). NAS concluded that there was no new evidence to change the previous determination that there is limited or suggestive evidence of no association between exposure to herbicides and gastrointestinal tract cancer. The evidence that suggests that there is no association between exposure to herbicides and gastrointestinal tumors also implies that Vietnam-veterans are not at increased risk of gastrointestinal tumors resulting from herbicide exposure. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and gastrointestinal tract tumors outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Brain Tumors The only well-established environmental risk factor for brain tumors is exposure to high doses of ionizing radiation. (American Cancer Society, 2004a; Wrensch *et al.* , 2002). Several other potential risk factors have been examined, but most brain cancers are not associated with any known risk factors. Brain cancer occurs fairly infrequently. NAS noted in VAO and subsequent reports that there was limited or suggestive evidence of no association between exposure to herbicides and brain tumors. An occupational study conducted in 2003 updated cancer mortality among Dow Chemical Company workers who were likely to have been exposed to high concentrations of dioxins. Cancers of the brain and nervous system were not elevated. (Bodner *et al.* , 2003). A 2004 study of the mortality of a cohort of 1,341 licensed herbicide appliers in the Netherlands showed an insignificant increase in brain cancer, but the study was limited by the small number of cases and by potential confounders that could not be evaluated. (Swaen *et al.* , 2004). No relevant environmental studies were published since Update 2002. A Vietnam-veteran study describes cancer incidence and mortality in a prospective cohort study of Air Force Operation Ranch Hand veterans who sprayed Agent Orange while serving in Southeast Asia. The Ranch Hand cohort was compared to a group of veterans who did not serve in Southeast Asia as well as U.S. national cancer rates. There was a non-significant increase in the incidence of cancer of the brain and nervous system compared with national rates, and a non-significant increase in Ranch Hand veterans who served during the heaviest use of Agent Orange. There was no increase in mortality attributable to cancer of the brain and nervous system. This study was limited by the small number of cases. (Akhtar *et al.* , 2004). NAS concluded that there was no new evidence to change the previous determination that there is limited or suggestive evidence of no association between exposure to herbicides and brain tumors. Taking account of the available evidence and NAS' analysis, the Secretary has found that the credible evidence against an association between herbicide exposure and brain tumors outweighs the credible evidence for such an association, and he has determined that a positive association does not exist. Conclusion NAS reviewed scientific and medical articles published since the publication of its first report as an integral part of the process that resulted in “Veterans and Agent Orange: Update 2004.” The comprehensive review and evaluation of the available literature that NAS conducted in conjunction with its report has permitted VA to identify all conditions for which the current body of knowledge supports a finding of an association with herbicide exposure. Accordingly, the Secretary has determined that there is no positive association between exposure to herbicides and any other condition for which he has not specifically determined that a presumption of service connection is warranted. After careful review of the NAS findings in Update 2004 and other pertinent information, the Secretary has determined that no new presumptions of service connection are warranted for any illnesses based on exposure to herbicides used during the Vietnam War or to dioxin. Approved: June 5, 2007. Gordon H. Mansfield, Deputy Secretary of Veterans Affairs. [FR Doc. E7-11247 Filed 6-11-07; 8:45 am] BILLING CODE 8320-01-P DEPARTMENT OF VETERANS AFFAIRS Advisory Committee on OIF/OEF Veterans and Families; Notice of Meeting The Department of Veterans Affairs
(VA)gives notice under Public Law 92-463 (Federal Advisory Committee Act) that a subcommittee of the Advisory Committee on OIF/OEF Veterans and Families will conduct a site visit in the Las Vegas, Nevada area on June 26-28, 2007. The site visit will include a town hall meeting, tours and briefings at various VA facilities, and a tour of Nellis AFB medical facilities. The town hall meeting will be open to the public. The purpose of the Committee is to advise the Secretary of Veterans Affairs on the full spectrum of health care, benefits delivery and related family support issues that confront servicemembers during their transition from active duty to veteran status and during their post-service years. The Committee focuses on the concerns of all men and women with active military service in Operation Iraqi Freedom and/or Operation Enduring Freedom, but pays particular attention to severely disabled veterans and their families. On June 26, the subcommittee will attend a veterans small business conference at the Caesars Palace Hotel and will receive afternoon briefings by Nellis AFB officials. On June 27, the subcommittee will tour several VA medical clinics and will receive briefings by Veterans Health Administration and Veterans Benefits Administration personnel on issues of particular relevance to OIF/OEF veterans and their families. The subcommittee will conduct a two hour town hall meeting beginning at 7 p.m. in the Jewel Box Theater at the Clark County Library, 1401 E. Flamingo Road, Las Vegas, Nevada. On June 28, the subcommittee will hold a wrap up session to review and analyze the previous days' briefings. That session will be held at the MGM Grand, 3799 Las Vegas Boulevard South, Las Vegas, Nevada. Public comments will be received by the subcommittee at the town hall meeting on June 27. Individuals wishing to make oral statements at the meeting should contact the Committee at *oifoef@va.gov.* Just prior to the town hall meeting, there will also be a sign up sheet for people to register their interest in making public statements. Oral statements by the public will be limited to five minutes each. Anyone seeking additional information should contact Ronald Thomas, Esq., Designated Federal Officer, at
(202)273-5182. Dated: June 6, 2007. By direction of the Secretary. E. Philip Riggin, Committee Management Officer. [FR Doc. 07-2889 Filed 6-11-07; 8:45 am]
Connectionstraces to 19
Traces to 19 documents
U.S. Code
26 references not yet in our index
  • 17 CFR 240.13
  • 17 CFR 228.308(a)
  • 17 CFR 228.308(a)(3)
  • 17 CFR 240.15
  • 17 CFR 240.19
  • 17 CFR 240.9
  • 15 USC 78
  • 728 F.2d 107
  • 295 F.3d 312
  • 421 U.S. 837
  • 494 U.S. 56
  • 382 F. Supp. 2d 580
  • 17 CFR 240.12
  • 17 CFR 240.3
  • 17 CFR 240.14
  • 17 CFR 240.200
  • 17 CFR 240.200(a)
  • 17 CFR 19
  • 14 CFR 147
  • 14 CFR 65
  • 49 CFR 555
  • 49 CFR 512
  • Pub. L. 107-103
  • Pub. L. 102-4
  • 105 Stat. 11
  • Pub. L. 92-463
Citation graph
cites case law
Notices
Temporary order and notice of application for a permanent order under section 9(c) of the Investment Company Act of 1940 (the “Act”)
C.F.R.§ 229.308
U.S.C.§ 78c
U.S.C.§ 78j–1
U.S.C.§ 552
U.S.C.§ 78s
U.S.C.§ 78f
C.F.R.§ 200.30-3
C.F.R.§ 242.600
U.S.C.§ 78p
F. App'x728 F.2d 107
F. App'x295 F.3d 312
SCOTUS421 U.S. 837
Cites 45 · showing 12Cited by 0 across 0 sources
★   the supreme law of the land   ★
Don't Tread on Me
E Pluribus Unum — out of many, one

"If you don't know your rights, you don't have any."

Marginalia · a citizen's law index
A research desk, not legal advice. Always read the cited source before relying on a summary.
Questions or an issue? support@self-law.org
disclaimerMarginalia is a research index, not a law firm. Nothing on this site is legal, tax, or financial advice and no attorney–client relationship is formed by using it. Statutes, regulations, and case law change; summaries, search results, AI output, and member posts may be incomplete, out of date, or wrong. Any interpretation drawn from material on this site should be validated by a licensed attorney in your jurisdiction before you act on it.