- SEC Issues Rules For The Independence Of Listed Companies' Audit Committees
- June 10, 2003
- Law Firm: Blank Rome LLP - Philadelphia Office
The Securities and Exchange Commission (the "SEC") has adopted final rules to implement Section 301 of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") with respect to the independence of audit committee members. In this regard, the SEC has adopted Exchange Act Rule 10A-3, which prohibits the listing of any security of an issuer by the national securities exchanges and national securities associations ("SROs") that is not in compliance with the requirements set forth in Section 301 of the Sarbanes-Oxley Act.
Rule 10A-3 became effective April 25, 2003. Each SRO must provide to the SEC proposed rules or amendments by July 15, 2003 that comply with the Exchange Act Rule 10A-3. In addition, each SRO must have final rules or rule amendments that comply with Rule 10A-3 approved by the SEC no later than December 1, 2003. Listed issuers, other than foreign private issuers and small business issuers, must be in compliance with the new listing rules by the earlier of (1) their first annual shareholders meeting after January 15, 2004, or (2) October 31, 2004. Foreign private issuers and small business issuers must be in compliance by July 31, 2005. These rules do not apply to reporting companies that are not listed companies.
The new rules have been promulgated to address investor confidence in the reliability of corporate financial information by ensuring that audit committees provide independent review and oversight of a company's financial reporting process, internal controls and independent auditors. Under Rule 10A-3:
- Each audit committee must be comprised of "independent" directors, subject to certain criteria.
- Each audit committee must be directly responsible for the appointment, compensation, retention and oversight of the work of the issuer's auditors. Auditors must report directly to the audit committee.
- Each audit committee must establish procedures for the receipt, retention and treatment of complaints regarding accounting, internal accounting controls or auditing matters, including procedures for the confidential, anonymous submissions by company employees of concerns regarding questionable accounting or auditing matters.
- Each audit committee must have the authority to engage independent counsel and other advisors, as it determines necessary to carry out its duties.
- Each issuer must provide appropriate funding for the audit committee.
- Listed companies must disclose additional information regarding their audit committees.
This Alert does not discuss the requirements of Rule 10A-3 as they apply to investment companies.
- Independence of Audit Committee Members
- Scope of the Requirement
The Sarbanes-Oxley Act requires that each audit committee member of a listed company be independent. In order to be qualified as independent, under Rule 10A-3 an audit committee member:
- may not accept directly or indirectly any consulting, advisory or other compensatory fee from the company or any of its subsidiaries, other than (1) in his or her capacity as a director or as a member of the audit committee or any other board committee and (2) fixed amounts of retirement or deferred compensation for prior service not contingent on continuing service; and
- may not be an affiliated person of the issuer or any of its subsidiaries, other than in his or her capacity as a member of the board.
These requirements are in addition to any independence standards maintained by the SROs.
- Advising, Consulting or Compensatory Fees
Under Rule 10A-3, payments to an audit committee member for service as an officer or employee are prohibited. Moreover, indirect payments are disallowed including the following:
- payments to entities in which the audit committee member is a partner, member, managing director or executive officer or holds a comparable position that provide accounting, consulting, legal, investment banking or financial advisory services to the listed company (except for payments to entities in which the audit committee member is a limited partner or non-managing member and does not have an active role in providing services to the entity).
- payments to spouses, minor children or stepchildren or children or stepchildren who share a home with the audit committee member.
The prohibitions on the compensation only applies to current relationships of audit committee members and does not "look back" to periods before a director's appointment to the audit committee. The SEC's final rule has no limitation or restriction on fees paid for services as a member of a board of directors or committees of the board. Dividend payments to an audit committee member who is a shareholder does not automatically disqualify him or her from being considered independent.
- Affiliated Person of the Issuer or Any Subsidiary Thereof
The second basic criterion for determining independence is that a member of the audit committee of an issuer may not be an "affiliated person" of the issuer or any subsidiary of the issuer, apart from his or her capacity as a member of the board and any board committee. An affiliated person is defined by the SEC to mean "a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the person specified." The SEC defines the term "control" consistent with other definitions of this term under the Exchange Act as "the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract or otherwise."
The determination of whether a person falls within the category of an affiliate requires a factual determination based on a consideration of all relevant facts and circumstances. However, the SEC has adopted a "safe harbor" under which a person who is not an executive officer and who does not beneficially own, directly or indirectly, more than 10% of any class of voting equity securities of a specified person will be deemed not to control such specified person and therefore will be deemed not to be an affiliate. The ownership prong is based on ownership of any class of voting equity securities, instead of any class of equity securities.
The 10% threshold is not an upper ownership limit for non-affiliate status. Rule 10A-3 specifically provides that the safe harbor does not create a presumption that a person exceeding the 10% ownership level controls or is otherwise an affiliate of a specified person. Therefore, a person who cannot rely on the safe harbor, but believes that they do not control an issuer, could still rely on a facts and circumstances analysis. For instance, under a facts and circumstances analysis of control, a director who is not an executive officer but beneficially owns more than 10% of the issuer's voting equity could be determined not to be an affiliate and thus could serve on the audit committee.
Although Rule 10A-3 does not establish an upper limit on share ownership that would automatically disqualify an individual from being deemed "independent," the SEC noted that SROs could propose such limits. For example, the NASD has proposed that an audit committee member should be considered an affiliated person of the issuer if the member owns or controls, directly or indirectly, more than 20% of a listed company's voting stock. Such an upper limit would automatically preclude a person from being independent (and therefore could preclude that person from membership on the audit committee) for the purpose of the SRO's rules, even though it would not, in and of itself, do so under Rule 10A-3.
- Scope of the Requirement
- Exemptions from Audit Committee Member Independence
The SEC has exempted from the independence requirements particular relationships with respect to audit committee members under Rule 10A-3 for:
- New Issuers
Companies coming to market for the first time may face particular difficulty in recruiting members that meet the independence requirements. As a result, the audit committee of a company must have at least one fully independent member at the time of an issuer's initial listing, a majority of independent members within 90 days after the effective date of the issuer's initial registration statement, and a fully independent committee within one year after such effective date.
- Overlapping Board Relationships
Rule 10A-3 exempts from the "affiliated person" requirement an audit committee member who sits on the board of directors of a listed issuer and any affiliate so long as, except for being a director on each such board of directors, the member otherwise meets the independence requirements for each entity, including the receipt of only ordinary-course compensation for serving as a member of the board of directors, audit committee or any other board committee of each such entity.
- Dual Holding Companies
Recognizing that certain foreign private issuers operate under a dual holding company structure, Rule 10A-3 provides an exemption:
- where a listed issuer is one of two dual holding companies, those companies may designate one audit committee for both companies so long as each member of the audit committee is a member of the board of directors of at least one of such dual holding companies; and
- dual holding companies will not be deemed to be affiliates of each other by virtue of their dual holding company arrangements with each other, including where directors of one dual holding company are also directors of the other dual holding company, or where directors of one or both dual holding companies are also directors of the businesses jointly controlled, directly or indirectly, by the dual holding companies (and in each case receive only ordinary-course compensation for serving as a member of the board of directors, audit committee or any other board committee of the dual holding companies or any entity that is jointly controlled, directly or indirectly, by the dual holding companies).
- Other Requests for Independence Exemptions
Issuers availing themselves of exemptions from Exchange Act Rule 10A-3 will generally have to disclose this fact. Apart from the exemptions discussed above and the exemptions for controlling persons, foreign governmental board representatives and non-management employee members of foreign private issuers discussed below, the SEC did not exempt other particular relationships from the independence requirements at this time. The SEC noted that despite the existence of exemptions based on exceptional and limited circumstances in several existing SRO rules, Rule 10A-3 does not contain any such exemptions. Given the policy and purposes behind the Sarbanes-Oxley Act, as well as to maintain consistency and to ease administration of the requirements by the SROs, the SEC does not intend to entertain exemptions or waivers for particular relationships on a case-by-case basis. However, the SEC maintains that it has exemptive authority to respond to, and will remain sensitive to, evolving standards of corporate governance, including changes in U.S. or foreign law, to address any new conflicts that cannot be anticipated at this time.
- Opportunity to Cure Defects
As required by Section 301 of the Sarbanes-Oxley Act, Rule 10A-3 requires the SROs to establish procedures that give issuers the opportunity to cure any defects that are causing them to fail to meet the audit committee standards of the Act, before the SRO can prohibit the listing of their securities as a result of such a failure. Such rules also may provide that if a member of an audit committee ceases to be independent in accordance with the requirements of Rule 10A-3 for reasons outside the member's reasonable control, that person, with notice by the issuer to the applicable SRO, may remain an audit committee member of the listed issuer until the earlier of the next annual shareholders meeting of the listed issuer or one year from the occurrence of the event that caused the member to be no longer independent.
- New Issuers
- Responsibilities of the Audit Committee
Rule 10A-3 requires that:
- the audit committee of a listed issuer be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm engaged (including resolution of disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report or performing other audit, review, or attest services for the issuer; and
- the independent auditor must report directly to the audit committee.
These oversight responsibilities include the authority to retain the outside auditor, which includes the power not to retain (or to terminate) the outside auditor. In addition, in connection with these oversight responsibilities, the audit committee must have ultimate authority to approve all audit engagement fees and terms.
Rule 10A-3 includes an instruction that the audit committee requirements do not conflict with, nor do they affect the application of, any requirement or ability under an issuer's governing law or documents or other home country legal or listing provisions that requires or permits shareholders to ultimately vote on, approve or ratify such requirements. However, if such responsibilities are vested with shareholders, and the issuer provides a recommendation or nomination regarding such matters to its shareholders, the audit committee of the issuer, or body performing similar functions, must be responsible for making the recommendation or nomination.
Rule 10A-3 also includes an instruction that clarifies that the audit committee requirements in the final rule, including the requirement that the audit committee provide recommendations to shareholders where such responsibilities are vested with shareholders, do not conflict with any legal or listing requirement in an issuer's home jurisdiction that prohibits the full board of directors from delegating such responsibilities to the audit committee or limits the degree of such delegation. However, the SEC noted that in such an instance, the audit committee, or body performing similar functions, must be granted such responsibilities, which can include advisory powers, with respect to such matters to the extent permitted by law, including submitting nominations or recommendations to the full board of directors.
- Procedures for Handling Complaints
Under the listing standards called for by Rule 10A-3, each audit committee must establish procedures for:
- the receipt, retention and treatment of complaints received by the issuer regarding accounting, internal accounting controls or auditing matters, and
- the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters.
The SEC did not mandate specific procedures that audit committees must establish, but expects each audit committee to develop procedures that work best consistent with its company's individual circumstances to meet the requirements in the final rule.
- Authority to Engage Advisors; Funding
To perform its role effectively, the SEC acknowledged that an audit committee may need the authority to engage its own outside advisors, including experts in particular areas of accounting, as it deems necessary, apart from counsel or advisors hired by management, especially when potential conflicts of interest with management may be apparent. Accordingly, Rule 10A-3 requires that the audit committee must have the authority to engage independent counsel and other advisers as it determines necessary to carry out its duties. Additionally, Rule 10A-3 requires the issuer to provide for appropriate funding, as determined by the audit committee, in its capacity as a committee of the board of directors, for payment of compensation to:
- any registered public accounting firm engaged for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the listed issuer; and
- any advisors employed by the audit committee.
Since an audit committee's effectiveness may be compromised if it is dependent on management's discretion to pay for the committee's expenses, especially when potential conflicts of interest with management may be apparent, Rule 10A-3 provides that, in addition to funding for advisors, the issuer must provide appropriate funding for ordinary administrative expenses of the audit committee that are necessary or appropriate in carrying out its duties.
- Affected Foreign Issuers
Rule 10A-3 applies to both domestic and foreign issuers with securities listed in the United States. The SEC acknowledged that some of the requirements of Rule 10A-3 may conflict with legal requirements, corporate governance standards and the methods for providing auditor oversight in the home jurisdictions of some foreign issuers, and therefore, have enumerated limited exceptions to address the situations of foreign private issuers including:
- Employee Representation
Employees of foreign issuers who are not executive officers can sit on the audit committee of a foreign private issuer if the employee is elected or named to the board of directors or audit committee of the foreign private issuer pursuant to the issuer's governing law or documents, an employee collective bargaining or similar agreement, or other home country legal or listing requirements.
- Two-Tier Board Systems
In the case of foreign private issuers with two-tier board systems consisting of a management board and a supervisory or non-management board, the term "board of directors" means the supervisory or non-management board for purposes of Rule 10A-3. As such, the supervisory or non-management board can either form a separate audit committee or, if the entire supervisory or non-management board is independent within the provisions and exceptions of the rule, the entire board can be designated as the audit committee.
- Controlling Shareholder Representation
One member of the audit committee can be a representative of a controlling shareholder of the foreign private issuer regardless of the level of stock ownership or other indicia of control, if:
- the "no compensation" prong of the independence requirements is satisfied;
- the member in question has only observer status on, and is not a voting member or the chair of, the audit committee; and
- the member in question is not an executive officer of the issuer.
- Foreign Government Representation
Any audit committee member can be a representative of a foreign government or foreign governmental entity that is an affiliate of the foreign private issuer, regardless of how the government holds its interest, if:
- the "no compensation" prong of the independence requirements is satisfied;
- the member in question is not an executive officer of the issuer.
- Listed Issuers that are Foreign Governments
Issuers that are foreign governments, as defined in Exchange Act Rule 3b-4(a) (all registrants that are eligible to register securities under Schedule B of the Securities Act) are exempt from the requirements of Rule 10A-3.
- Boards of Auditors or Similar Bodies
The listing of securities of a foreign private issuer will be exempt from all of the audit committee requirements if the issuer meets the following requirements:
- The foreign private issuer has a board of auditors (or similar body), or has statutory auditors (collectively, a "Board of Auditors"), established and selected pursuant to home country legal or listing provisions expressly requiring or permitting such a board or similar body;
- The Board of Auditors is required by the home country legal or listing requirements to be either separate from the board of directors, or composed of one or more members of the board of directors and one or more members that are not also members of the board of directors;
- The Board of Auditors are not elected by management of the issuer and no executive officer of the issuer is a member of the Board of Auditors;
- Home country legal or listing provisions set forth or provide for standards for the independence of the Board of Auditors from the issuer or the management of the issuer;
- The Board of Auditors, in accordance with any applicable home country legal or listing requirements or the issuer's governing documents, is responsible, to the extent permitted by law, for the appointment, retention and oversight of the work of any registered public accounting firm engaged (including, to the extent permitted by the law, the resolution of disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the issuer; and
- The remaining requirements of Rule 10A-3 concerning the establishment of complaint procedures, authority to engage advisors and funding apply to the Board of Auditors, to the extent permitted by law.
The SEC eliminated the proposed requirement that the issuer must also be listed on a market outside of the United States.
- Other Exemptions.
The SEC noted that there would be no other ability for an SRO to exempt or waive foreign issuers from the independence requirements. The SEC recognized that corporate governance structures throughout the world will continue to evolve, and that all future conflicts cannot be presently anticipated. Accordingly, the SEC has the authority to respond to, and will remain sensitive to, the evolving standards of corporate governance throughout the world to address any new conflicts that may arise with foreign corporate governance rules and practices.
- Employee Representation
- Disclosure Changes Regarding Audit Committees
- Disclosure Regarding Exemptions
Issuers that avail themselves of one of these exemptions must disclose in, or incorporate by reference into, their Annual Reports on Form 10-K or Form 10-KSB (Form 20-F or Form 40-F in the case of a foreign private issuer) filed with the Commission:
- their reliance on an exemption; and
- their assessment of whether, and if so, how, such reliance would materially adversely affect the ability of their audit committee to act independently and to satisfy the other requirements of Exchange Act Rule 10A-3.
In addition, the disclosure must appear in proxy statements or information statements of issuers subject to the SEC's proxy rules for shareholders' meetings at which elections for directors are held.
- Identification of the Audit Committee in Annual Reports
An issuer subject to the proxy rules of Section 14 of the Exchange Act is currently required to disclose in its proxy statement or information statement, if action is to be taken with respect to the election of directors, whether the issuer has a standing audit committee, the names of each committee member, the number of committee meetings held by the audit committee during the last fiscal year and the functions performed by the committee. Rule 10A-3 requires that disclosure of the members of the audit committee be included or incorporated by reference in the listed issuer's annual report.
Also, because the Exchange Act now provides that in the absence of an audit committee the entire board of directors will be considered to be the audit committee, the rules require a listed issuer that has not separately designated, or has chosen not to separately designate an audit committee, to disclose that the entire board of directors is acting as the issuer's audit committee.
Listed issuers that are not required to provide disclosure of their reliance on one of the exemptions to the rule, such as a subsidiary relying on the multiple listing exemption, a foreign government issuer or an asset-backed issuer or similar issuer, are excluded from the requirement to disclose whether or not they have a separate audit committee.
- Updates to Existing Audit Committee Disclosure Requirements
An issuer subject to the proxy rules is currently required to disclose additional information about its audit committee in its proxy statement or information statement, if action is to be taken with respect to the election of directors. The audit committee must provide a report disclosing whether the audit committee has reviewed and discussed the audited financial statements with management and discussed certain matters with the independent auditors. Second, issuers must disclose whether the audit committee is governed by a charter, and if so, include a copy of the charter as an appendix to the proxy statement at least once every three years. Finally, the issuer must disclose whether the members of the audit committee are independent.
Under the existing requirements, issuers whose securities are listed on the NYSE or AMEX or quoted on Nasdaq must disclose whether the audit committee members are independent, as defined in the applicable listing standards. Non-listed issuers are also required to disclose whether their audit committee members are independent and may choose which definition of independence to use from any of the NYSE, AMEX or Nasdaq listing standards. Under Rule 10A-3, all SROs need to have independence standards for audit committee members, not just the NYSE, AMEX and Nasdaq.
- Application to Foreign Private Issuers
The SEC adopted amendments to the audit committee financial expert disclosure provisions as they apply to foreign private issuers. If the foreign private issuer is listed, the amendments require that the issuer disclose whether its audit committee financial expert is independent, as that term is defined by the SRO listing standards applicable to that issuer. If a foreign private issuer is not listed, it must choose one of the SRO definitions of audit committee member independence that have been approved by the SEC in determining whether its audit committee financial expert, if it has one, is independent. It must also disclose which definition was used. Foreign private issuers need not comply with these disclosure requirements until July 31, 2005.
- Disclosure Regarding Exemptions