BUSINESS DEPARTMENT E-NEWS ALERT — JUNE 13, 2003
SEC Final Rules Regarding Audit Committee
Standards for Listed Companies
Overview
As directed by the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”), the Securities and Exchange
Commission (the "SEC") recently adopted a new rule1 directing the national securities exchanges and
national securities associations such as the New York Stock Exchange and the Nasdaq Stock Markets
(called self-regulated organizations or "SROs") to prohibit the listing of any security of an issuer that is
not in compliance with the audit committee requirements established by Sarbanes-Oxley. The rule
applies to public companies that have their stock listed on a national securities exchange or on an
automated interdealer quotation system of a national securities association (e.g., Nasdaq National or
SmallCap Markets—companies whose securities trade on the OTC Bulletin Board (OTCBB), the Pink
Sheets and the Yellow Sheets are not affected), and provides for:
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The independence of audit committee members;
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The audit committee's selection and oversight of the company's independent accountants;
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The audit committee's establishment of procedures for handling complaints regarding the
company's accounting practices;
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The audit committee’s ability to engage independent counsel and other advisors; and
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The company's obligation to fund the independent auditor and any outside advisors engaged
by the audit committee.
The following briefly summarizes the rule as adopted and highlights some of the differences between
the initially proposed rule2 and the final rule.
Timing and Implementation of the Standards
The SROs are required to issue or modify their listing standards to conform to the requirements set
forth in the final rule and are not precluded from adopting more stringent listing standards regarding
audit committees. Under the final rule, each SRO must provide to the Commission proposed rules or
rule amendments that comply with the requirements no later than July 15, 2003. Final rules or rule
amendments must be approved by the Commission no later than December 1, 2003. The final rule
applies not just to voting equity securities, but to any listed security, regardless of its type, including
debt securities, derivative securities and other types of listed securities. Under the final rule, listed
companies, 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 companies must be in compliance with the new listing rules by July 31, 2005.
1 Final Rule: Standards Relating to Listed Company Audit Committees, Securities Act Rel. No. 33-8220, Exchange Act
Rel. No. 34-47654, http://www.sec.gov./rules/final/33-8220.htm.
2 Proposed Rule: Standards Relating to Listed Company Audit Committees, Securities Act Rel. No. 33-8173,
Exchange Act Rel. No. 34-47137, http://www.sec.gov./rules/proposed/34-47137.htm.
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Companies contemplating an initial public offering must be prepared to comply with the rules once they
are listed. Recognizing the difficulty young companies may face in recruiting qualified, independent
directors, the final rule provides an exception for non-investment companies that requires at least one
fully independent member at the time of a company’s initial listing, a majority of independent members
within 90 days, and a fully independent committee within one year. This differs from the proposed rule,
which provided an exemption for one member of a non-investment company’s audit committee from the
independence requirements for 90 days from the effective date of a company’s initial registration
statement.
Audit Committee Member Independence
Members of the audit committee must be independent. To satisfy the independence requirement an
audit committee member may not:
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receive any kind of payment from the company other than in the member's capacity as a
director and member of the audit committee, or
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be an affiliate of the company or its subsidiary.
An audit committee is defined as a committee established by the board of directors of a company for
the purpose of overseeing the accounting and financial reporting processes of the company and audits
of the financial statements of the company. If an audit committee has not been established, the entire
board will be the audit committee by default. In such case, the independence requirements relating to
audit committees would apply to the entire board.3
Under the first prong of the independence requirement, an audit committee member may not receive
any kind of payment from the company other than in the member's capacity as a director and member
of the audit committee. Since audit committee members may receive payment only in their capacity as
directors, it follows that officers, other company employees, and paid consultants and advisors may not
serve on the audit committee. Indirect payments are also prohibited, including payments to immediate
family members as well as payments accepted by an entity in which an audit committee member is a
partner, member, officer such as managing director occupying a comparable position or executive
officer, or occupies a similar position, and which provides accounting, consulting, legal, investment
banking, or financial advisory services to the company. The rule does not cover payments accepted by
an entity in which an audit committee member does not have an active role in providing services to the
entity. Furthermore, unless an SRO’s listing rules provide otherwise, compensatory fees do not include
the receipt of fixed amounts of compensation under a retirement plan (including deferred
compensation) for prior service with the listed company, provided that such compensation is not
contingent in any way on continued service.
3 Where a listed entity is a limited partnership or limited liability company that does not have a board of directors or
equivalent body, the term “board of directors” means the board of directors of the managing general partner, managing
member or equivalent body.
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Under the second prong of the independence requirement, an audit committee member may not be an
affiliated person of the company or its subsidiaries. An “affiliate” is defined as a person that directly, or
indirectly through one or more intermediaries, controls, or is controlled by, or is under common control
with, such person. “Control” is defined as the possession, direct or indirect, of the power to direct or
cause the direction of management and policies of a person, whether through ownership of voting
securities, by contract, or otherwise. Only executive officers and directors that are also employees of
an affiliate and general partners and managing members of an affiliate are automatically deemed to be
affiliates. This formulation is narrower than the proposed rule and clarifies that passive, non-control
positions, such as limited partners, and those that do not have policy making functions, are not
covered.
The final rule adds a safe harbor—an audit committee member will not be deemed to be an affiliated
person if he or she is not an executive officer or an owner of more than 10% of the company’s
outstanding securities. Failure to meet the 10% ownership threshold will not automatically mean that
the shareholder is an affiliate. Instead a facts and circumstances analysis of control should be
conducted to determine whether such shareholder is an affiliate.
An audit committee member may sit on the board of directors of a listed company 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 entity.
Responsibilities Relating to Registered Public Accounting Firms
The rule requires that the audit committee be directly responsible for the appointment, compensation,
retention and oversight of the work of any registered public accounting firm that the company engages
(including resolution of disagreements between management and the auditor regarding financial
reporting) to prepare or issue an audit report or perform other audit, review or attest services. The
independent auditor is required to report directly to the audit committee.
Procedures for Handling Complaints
The rule places an affirmative obligation on the audit committee to handle complaints. Audit
committees must establish procedures for the receipt, retention and treatment of complaints received
by the company regarding accounting, internal accounting controls or auditing matters as well as
procedures for the confidential, anonymous submission by employees of the company of concerns
regarding questionable accounting or auditing matters. The rule stops short of recommending or
mandating specific procedures, providing companies with the flexibility to develop procedures
appropriate to their circumstances. However, this should not be understood to be a license to establish
vague or ineffectual procedures because implemented procedures must adequately address and
follow-through with filed complaints. Companies should consider using a third-party telephone hotline
provider and/or a web-based submission service to ensure that submissions of complaints are kept
confidential and anonymous. In addition, companies should review any existing whistleblower policies
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in place in order to ensure consistency with complaint reporting procedures that may be set forth
elsewhere (i.e., in the company’s code of ethics or employee handbook).
Authority to Engage Advisors
The SEC recognizes that the audit committee likely is not equipped to self-advise on all accounting,
financial reporting or legal matters and that the committee may need expert assistance in these areas.
Accordingly, the rule specifically requires that the audit committee be given authority to engage outside
advisors, including legal counsel, as it determines necessary to carry out its duties.
Funding
The authority to appoint advisors would be eviscerated and the independence of the audit committee
compromised if the audit committee did not have authority to pay those advisors. Accordingly, the rule
requires the company to provide for appropriate funding, as determined by the audit committee 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 company;
and to any advisors employed by the audit committee. In addition, the rule requires companies to
provide funding for ordinary administrative expenses of the audit committee that are necessary or
appropriate in carrying out its duties.
Foreign Private Issuers
Where a foreign private issuer has a two-tier board system, the supervisory or non-management board
is the body best equipped to comply with the requirements. As such, the supervisory or nonmanagement board can either form a separate audit committee or the entire board can be designated
as the audit committee.
A number of foreign countries have rules relating to the audit process that conflict with the rule.
Therefore, the rule has special provisions for foreign private issuers which, if certain conditions are met,
allow non-management employees, representatives of shareholder groups, and government
representatives to serve on the audit committee where required by home country rules. Issuers that
are themselves foreign governments are exempt from the rule requirements. Further exemptions relate
to those countries that provide auditor oversight through statutory auditors or special boards of
auditors.
New amendments to the to the audit committee financial expert disclosure provisions have been
amended as they apply to foreign private issuers. The amendments require a listed foreign private
issuer to disclose whether its audit committee expert is independent, as that term is defined by the SRO
listing standards applicable to that issuer. Foreign private issuers need not comply with these
disclosure requirements until July 31, 2005.
Disclosure Changes Regarding Audit Committees
The rule requires a listed company to disclose in its annual reports and proxy statements:
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Members of the audit committee, or if a company has not separately designated, or has
chosen not to separately designate an audit committee, that the entire board of directors is
acting as the company’s audit committee;
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Whether members of its audit committee are independent, or if the company does not have a
separately designated audit committee, the same disclosure with respect to all members of its
board of directors; and
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Whether the company is relying on any exemption from the audit committee requirements and
whether, and if so, how such reliance would adversely affect the ability of the audit committee
to perform its function.
Companies must comply with the new disclosure changes beginning with reports covering periods
ending on or after (or proxy or information statements for actions occurring on or after) the compliance
date for the listing standards applicable to the particular company.
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For more information on this E-News Alert, please contact Stephan Coonrod (stephanc@prestongates.com)
or any other attorney in the Securities Group at Preston Gates & Ellis LLP.
The enclosed materials have been prepared for general informational purposes only and are not intended
as legal advice.
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