- SEC Proposes Standards Relating to Listed Company Audit Committees
- May 27, 2003
- Law Firm: Womble Carlyle Sandridge & Rice - Winston-Salem Office
As directed by the Sarbanes-Oxley Act of 2002 (the "Act"), the Securities and Exchange Commission (the "SEC") recently issued a proposed rule that would direct the national securities exchanges1 and national securities associations (collectively referred to in this article as, "listing organizations") to prohibit the listing of any security of an issuer2 that is not in compliance with audit committee standards established by the Act. The standards, which are designed to enhance the accuracy and reliability of the financial reporting process, relate to: the independence of audit committee members; the audit committee's responsibility to select and oversee the issuer's independent auditor; procedures for handling complaints regarding the issuer's accounting practices; the authority of the audit committee to engage advisors; and funding for the independent auditor and any outside advisors engaged by the audit committee. The proposed rule is now subject to a 30¿day comment period, and the Act requires that the final rule become effective by April 26, 2003. As proposed, the new audit committee standards would need to be made operative by the listing organizations no later than the first anniversary of the publication of the final rule in the Federal Register.
Under proposed Rule 10A-3 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), listing organizations would be prohibited from listing any security of an issuer that is not in compliance with the following audit committee3 standards:
- each member of the audit committee must qualify, based on specified criteria, as independent;
- the audit committee must be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm4 engaged for the purpose of preparing or issuing an audit report or related work or performing other audit, review or attest services for the issuer, and each such registered public accounting firm must report directly to the audit committee;
- the audit committee must establish "whistleblower" procedures for the receipt, retention and treatment of complaints regarding accounting, internal accounting controls or auditing matters, including procedures for the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters;
- the audit committee must have the authority to engage independent counsel and other advisors as it determines necessary to carry out its duties; and
- the issuer must provide appropriate funding for the audit committee.
Discussion of Proposed Standards:
Audit Committee Member Independence. The proposed standards relating to audit committee member independence reflect the SEC's belief that an independent audit committee is better equipped to satisfy the obligations of the audit committee mandated by the Act, including overseeing a sound system of internal controls, approving any non-audit services by the outside auditor and enhancing the independence of the audit function. The proposed standards provide two criteria for determining independence, and the SEC proposal contemplates that listing organizations may identify additional criteria in their listing requirements. First, an audit committee member must not accept (directly or indirectly) any consulting, advisory or other compensatory fee from the issuer or an affiliate of the issuer, other than in the member's capacity as a member of the board of directors and any board committee. This prohibition would preclude payments to a member as an officer or employee, as well as other direct or indirect compensatory payments. Indirect payments would include payments (i) to spouses, minor children or stepchildren or children or stepchildren sharing a home with an audit committee member, and/or (ii) accepted by an entity in which an audit committee member is a partner, member or principal or occupies a similar position and which provides accounting, consulting, legal, investment banking, financial or other advisory services or any similar services to the issuer. Second, an audit committee member must not be an affiliated person, as determined based on the particular facts and circumstances, of the issuer or any subsidiary of the issuer5 except, obviously, in the audit committee member's capacity as a member of the board and any board committee. The SEC proposal defines "affiliated person" consistent with its traditional definitions of "affiliate" and "control,"6 and the SEC has proposed a non-exclusive safe harbor that would provide that a person who is not an executive officer, director or ten percent shareholder of the issuer would be deemed not to control the issuer and therefore would not be an affiliated person of the issuer. It should be noted that the SEC's proposal eliminates the "exceptional and limited circumstances" exception to audit committee independence requirements that exist currently under the rules of several listing organizations.
To alleviate some of the difficulty that companies just entering the market may have in recruiting independent directors, the SEC proposed to exempt one member of the issuer's audit committee from the independence requirements for 90 days from the effective date of the issuer's initial registration statement under Section 12 of the Exchange Act or a registration statement under the Securities Act of 1933, as amended, covering an initial public offering of securities of the issuer. Additionally, the SEC proposed to exempt from the "affiliated person" requirement a committee member that sits on the board of directors of both a parent and a direct or indirect consolidated, majority-owned subsidiary, if the member otherwise meets the independence requirements for both the parent and subsidiary. Issuers relying on these exemptions would be required to disclose such reliance, as well as an assessment of whether and, if so, how such reliance would materially adversely affect the ability of the audit committee to act independently and to satisfy the other requirements of proposed Exchange Act Rule 10A-3, in their annual reports filed with the SEC, as well as in proxy statements or information statements for shareholders' meetings at which elections of directors are held.
Responsibilities Relating to Registered Public Accounting Firms. The proposed standards would require that audit committees be directly responsible for the appointment, compensation (and the issuer would be required to provide appropriate funding, as determined by its audit committee, for such compensation), retention and oversight (including resolution of disagreements between management and the auditor regarding financial reporting) of the work of the independent auditor engaged for the purpose of preparing or issuing an audit report or related work or performing other audit, review or attest services for the issuer.7 The proposal would also require that the independent auditor report directly to the audit committee. Oversight responsibilities would include the authority to terminate the outside auditor. Additionally, consistent with the Act, the audit committee would be required to have ultimate authority to approve all audit engagement fees and terms, as well as all significant non-audit engagements of the independent auditor. If the governing law or documents of an issuer require shareholders to elect, approve or ratify the issuer's auditor, the audit committee must be responsible for any nomination or recommendation that the issuer makes (although the requirement is not intended to conflict with or affect any such governing documents or applicable state law).
Procedures for Handling Complaints. The proposed standards would require audit committees to 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. Neither the Act nor the SEC proposal mandates the specific procedures that must be established, but issuers will need to assess their "whistleblower" and other corporate compliance procedures to ensure compliance with these standards, as well as Section 806 of the Act (which protects whistleblower employees against retaliation by public companies).
Authority to Engage Advisors; Funding. The SEC's proposed standards would require that audit committees have the authority to engage outside advisors, including counsel, as they deem necessary to carry out their duties. Accordingly, the issuer would be required to provide appropriate funding, as determined by its audit committee, for payment of compensation to any advisors employed by the audit committee.
Application and Implementation of the Proposed Standards. The SEC's proposed standards would require listing organizations to issue or modify their rules, subject to SEC review, to conform their listing standards (to the extent that their listing standards do not already comply with the proposals), with such new standards to be operative no later than the first anniversary of the publication of the SEC's final rule in the Federal Register. Listing organizations are not precluded from adopting additional listing standards regarding audit committees, as long as such additional listing standards are consistent with the proposed rule.
The SEC's proposed rule applies to domestic and foreign private issuers listed by any listing organization, including small business issuers. Issuers with securities quoted on the OTC Bulletin Board, the Pink Sheets or the Yellow Sheets, none of which is a national securities exchange or national securities association, are not affected by the proposals, unless their securities are also listed by a listing organization. Additionally, the proposed rule applies to closed-end investment companies and exchange-traded open-end investment companies, but the SEC has proposed to exclude application to exchange-traded unit investment trusts.
Compliance with Proposed Standards.
The SEC proposed to direct listing organizations to require listed issuers to notify the appropriate listing organization promptly after an executive officer of such issuer becomes aware of any material noncompliance by such issuer with the requirements of the listing organization relating to audit committee standards.8
Disclosure Requirements Regarding Audit Committees.
In addition to the proposed disclosure requirement for reliance on exemptions described above, the SEC proposals would require disclosure of the names of the members of the audit committee in the issuer's annual report (as well as in the proxy statement). With respect to currently effective proxy rule disclosure requirements pertaining to audit committees, the SEC clarified that: (i) disclosure of the use of an "exceptional and limited circumstances" exception to independence requirements would no longer be necessary; (ii) issuers would continue to be required to disclose whether members of its audit committee are independent, but each issuer listed by a listing organization other than NYSE, AMEX or Nasdaq would determine independence in accordance with its listing organization's listing standards; and (iii) it would update disclosure requirements regarding the independence of audit committee members to reflect the new listing standards to be implemented by listing organizations in accordance with the SEC's proposed new rule.
1A "national securities exchange" is an exchange registered as such under Section 6 of the Securities Exchange Act of 1934, including the American Stock Exchange (AMEX) and the New York Stock Exchange (NYSE). A "national securities association" is an association of brokers and dealers registered as such under Section 15A of the Exchange Act. The National Association of Securities Dealers, Inc. (NASD), the parent company of The Nasdaq Stock Market, Inc. (Nasdaq), is currently the only national securities association.
2An "issuer" (as defined in Section 3(a)(8) of the Exchange Act) is subject to the Act if (1) the issuer's securities are registered under Section 12 of the Exchange Act, (2) the issuer is required to file reports under Section 15(d) of the Exchange Act, or (3) the issuer files or has filed, a registration statement that has not yet become effective under the Securities Act of 1933, as amended, and that has not been withdrawn.
3Under Section 3(a)(58) of the Exchange Act (which was added to the Exchange Act by Section 205 of the Act), an issuer either may have a separately designated audit committee comprised of members of its board or, if it elects not to form a separate committee, the entire board of directors would constitute the audit committee. If the entire board constitutes the audit committee, the SEC's proposed standards for listed company audit committees would apply to the issuer's board as a whole.
4The term "registered public accounting firm" is defined in Section 2(a)(12) of the Act. Until the Public Company Accounting Oversight Board contemplated by the Act has established a registration requirement for public accounting firms, the proposed requirement relating to the audit committee's oversight would refer to the public accounting firm employed by the issuer for the purposes indicated.
5Investment companies are excepted from this requirement because the Investment Company Act of 1940, as amended (the "Investment Company Act"), already precludes a member of the audit committee of an issuer that is an investment company from being an "interested person" of the investment company.
6The SEC defines (i) "affiliate" of, or a person "affiliated" with, a specified person, to mean a "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," and (ii) the term "control" to mean "the possession, directly or indirectly, of the power to direct or cause the direction of the management and policy of a person, whether through the ownership of voting securities, by contract, or otherwise." The proposed standards make clear that a director, executive officer, partner, member, principal or designee of an affiliated person of an issuer would also be deemed to be an affiliated person of that issuer.
7Investment companies would be exempt from the requirement that the audit committee be responsible for the selection of the independent auditor, as Section 32(a) of the Investment Company Act currently addresses the same concern by requiring that independent auditors of registered investment companies be selected by the majority vote of the disinterested directors.
8The SEC encourages listing organizations to impose a similar notification requirement for noncompliance with their other corporate governance standards. Additionally, the SEC proposed rule would require listing organizations to establish procedures for an issuer to have an opportunity to cure, prior to imposition of any prohibition or delisting, any defects that would be a basis for prohibiting the listing of or delisting the issuer's securities as a result of such issuer's failure to meet the proposed audit committee standards. To the extent existing continued listing or maintenance standards of listing organizations are insufficient, listing organizations would be required to establish definite procedures and time periods for compliance.