Kirkpatrick & Lockhart LLP
Bank & Thrift Regulatory UPDATE
FEBRUARY 2003
The Bank and Thrift Regulatory practice group of Kirkpatrick & Lockhart LLP is pleased to present the inaugural
issue of Bank & Thrift Regulatory UPDATE. We intend to produce the UPDATE approximately every other
month to cover legislative and regulatory developments of interest to financial institutions. We welcome
your comments on the UPDATE, as well as your questions about the topics covered. The last page of this
UPDATE contains a list of contacts for our Bank and Thrift Regulatory practice group to whom these items
may be addressed.
Depository Institution Audit Committee Membership
After Sarbanes-Oxley
The enactment of the Sarbanes-Oxley Act of 2002
(“Sarbanes-Oxley”), the adoption of implementing
regulations by the Securities and Exchange Commission
(the “SEC”), and the pending adoption of amendments
to the New York Stock Exchange Listed Company
Manual, the American Stock Exchange Company Guide
and the NASD Rules (collectively, the “Market Rules”)
will significantly affect the composition of audit
committees of publicly held companies. The SarbanesOxley audit committee requirements will apply only to
companies that are subject to the reporting requirements
of the Securities Exchange Act of 1934, as amended,1
and the Market Rules will only apply to companies
whose securities are traded on the respective markets.
However, these developments will not only affect
publicly held depository institutions—both banks and
thrift institutions—or holding companies, but also could
affect the composition of audit committees of other
depository institutions as well.
An insured depository institution or holding company
that is publicly held will have to comply with SarbanesOxley, the relevant Market Rules2 and existing Federal
Deposit Insurance Corporation (“FDIC”) regulations
governing audit committee composition. Insured
depository institutions that are not publicly held do not
need to comply with Sarbanes-Oxley or the Market
Rules, but those with total assets in excess of $500
million may become subject to revisions to the existing
FDIC regulations that may incorporate some of the
concepts introduced by Sarbanes-Oxley and the Market
Rules. Moreover, non-publicly held depository
institutions may consider conforming to some or all of
the standards applicable to publicly held depository
institutions in order to protect themselves against the
possibility of regulatory or other criticism.
This UPDATE will describe the provisions of SarbanesOxley (along with implementing regulations proposed
or adopted by the SEC) and the Market Rules, and
compare them to the existing FDIC regulations
governing the composition of audit committees.
THE SARBANES-OXLEY ACT OF 2002
Sarbanes-Oxley contains two important reforms
affecting audit committee composition: a mandate that
each stock exchange and market prohibit the listing of a
company that does not have an audit committee
comprised solely of independent directors and a
requirement that each publicly held company disclose
whether or not its audit committee has a financial expert
member.
The term “publicly held” as used in this UPDATE refers to companies that are subject to such reporting requirements.
Depository institutions and depository institution holding companies, whose securities are not listed on any market, are not subject to the
Market Rules or other similar listing requirements, even if trades in such securities are quoted on either the OTC Bulletin Board or Pink Sheets
quotation systems.
1
2
Kirkpatrick & Lockhart LLP
Bank & Thrift Regulatory UPDATE
FEBRUARY 2003
Independence Requirements
Section 301 of Sarbanes-Oxley requires the SEC to
direct the self-regulatory organizations (i.e. the stock
exchanges and markets) to prohibit the listing of any
company whose audit committee is not comprised solely
of “independent” directors. Although Sarbanes-Oxley
does not define the term “independent,” the statute
provides that a director is not “independent” if he or
she, other than in his or her capacity as a director or
audit committee member of the company, accepts any
consulting, advisory, or other compensatory fee from
the company, or is an affiliated person of the company
or any of its subsidiaries. The SEC’s recently proposed
Rule 10A-3 under the Securities Exchange Act of 1934
(“Proposed Rule 10A-3”), which would require
compliance on or before the one-year anniversary of
publication of the final rule, provides narrow exceptions
to the independence requirement. 68 Fed. Reg. 2638
(Jan. 17, 2003). The proposed rule also modifies the
definition of “independent” and defines the term
“affiliated person.”
Proposed Rule 10A-3 provides an exception to the
independence requirement for directors who are
otherwise independent but for the fact that they sit on
the board of both a listed company and its direct or
indirect consolidated majority-owned subsidiary or
parent company. Thus, a holding company and its
subsidiary may have mirror boards without affecting the
independence of audit committee members. There is
also a limited exception for one member of a listed
company’s audit committee for 90 days from the date of
effectiveness of a registration statement covering an
initial public offering. In addition, there are detailed
exceptions relating to foreign private issuers and a
general exception at the discretion of the SEC.
The definition of independence is narrowed in Proposed
Rule 10A-3 to disqualify a director who directly or
indirectly accepts a compensatory fee from the
company. “Indirectly” accepting compensation is
defined as including the acceptance of compensation by
certain family members, as well as by an entity in which
an audit committee member is a partner, member or
principal where the entity provides accounting, legal,
consulting or other advisory services to the issuer.
“Affiliate” or “person affiliated with” are defined as a
person who directly or indirectly controls, is controlled
by, or is under common control with the company. A
safe harbor provision excludes from treatment as an
2
affiliated person anyone who is the beneficial owner of
less than 10% of any class of equity securities of the
company, is not an executive officer of the company,
and is not a director of the company. Proposed Rule
10A-3 also provides that any person who is an executive
officer, partner, member, principal or designee of an
affiliate is an affiliated person.
The SEC also proposed an amendment to Item 7 of
Schedule 14A (information required in a proxy
statement) to require disclosures as to whether a
company’s audit committee meets the independence
requirements set forth in Proposed Rule 10A-3.
Financial Expert Requirements
Section 407 of Sarbanes-Oxley requires the SEC to
adopt rules mandating disclosure by each publicly held
company as to whether its audit committee has at least
one member who is a “financial expert.” The final rule
addressing this requirement was published recently in
the Federal Register (68 Fed. Reg. 5110 (Jan. 31,
2003)), and becomes effective on March 2, 2003.
Despite opposition from industry trade groups, the SEC
expanded upon the definition of “financial expert” in
Sarbanes-Oxley and redesignated the statutory term
“financial expert” as “audit committee financial expert.”
Publicly held companies will generally be required to
provide disclosures in their annual reports for fiscal
years ending after June 15, 2003. One is qualified to be
an “audit committee financial expert” of a company if
he or she has all of the following: an understanding of
financial statements, generally accepted accounting
principles, audit committee functions and internal
controls and procedures for financial reporting;
experience preparing, auditing, analyzing or evaluating
financial statements that are comparable in scope to
those of the company; and an ability to assess the
general application of accounting principles in
connection with the accounting for estimates, accruals
and reserves.
Such understanding, experience and ability must be
acquired through:
n
experience working as, or supervising, a principal
financial officer, public accountant or person in a
similar capacity;
n
overseeing or assessing the performance of
companies or public accountants with respect to
financial statements; or
n
“other relevant experience.”
BANK & THRIFT REGULATORY UPDATE
Bank & Thrift Regulatory UPDATE
FEBRUARY 2003
Each publicly held company will be required to disclose
that its board of directors has determined that either the
company has an audit committee financial expert or
does not. If a company’s board of directors has
determined that the company does not have an audit
committee financial expert, the company is required to
disclose that fact along with an explanation of the
reasons for the lack of such an expert. Publicly held
companies will also be required to disclose whether
their audit committee financial expert is “independent,”
as defined in Item 7 of Schedule 14A.
The SEC has provided a safe harbor with respect to
audit committee financial experts, which provides that
the audit committee financial expert is not an expert for
purposes of asserting liability under the Securities Act
of 1933. Also, the safe harbor makes clear that the
designation of a person as an audit committee financial
expert does not impose any additional duties upon such
person. Conversely, the presence of an audit committee
financial expert does not affect the duties of other
directors or audit committee members.
MARKET RULES
The New York Stock Exchange (“NYSE”), the
American Stock Exchange (“AMEX”) and the
NASDAQ Stock Market (“NASDAQ”) have each
proposed changes to the requirements for audit
committees of companies listed on their respective
markets. Each set of Market Rules already provides
that the audit committee of each company listed on the
respective market must be comprised solely of
independent directors. The proposed amendments to
the Market Rules enhance the existing requirements by
setting forth mandatory disqualifications from
independence, some of which are only applicable when
determining whether an audit committee member is
independent. The NYSE and the NASDAQ have made
their proposed rule changes public, while the AMEX
has released to the public only a summary of its
proposed rule changes.
As discussed below, proposed amendments to the New
York Stock Exchange Listed Company Manual (the
“NYSE Manual”) and the NASD Rules would add
disqualifications from independence based upon
affiliation with the company’s auditors and interlocking
compensation committees with other companies, as well
as a “cooling-off” period for directors who sever the
ties that disqualify them. In addition, each set of
Market Rules already requires a financial expert on
public company audit committees. However, Proposed
Rule 10A-3 would require revisions to proposed
amendments to the Market Rules to ensure that they
comply with the standards set forth in Proposed Rule
10A-3.
Independence Requirements
Subsection 1 of proposed Section 303A of the NYSE
Manual provides that, in order for a director to be
considered independent, the entire board of a company
must affirmatively determine that the director has no
material relationship with the company. A director is
disqualified from being independent based on the
director’s or the director’s family members’ employment
with the company, employment with the company’s
auditors or employment by another entity that has an
interlocking compensation committee with the company.
Each of the disqualifications is subject to a five-year
cooling-off period. Subsection 6 of proposed Section
303A provides a disqualification if an audit committee
member receives compensation from the company other
than for service on the board.
Proposed amended NASD Rule 4200(a)(15) provides
disqualifications that are much more complex and
limited than those in either Proposed Rule 10A-3 or the
NYSE Manual. In general, the proposed NASD Rule
would contain disqualifications similar to those
proposed by the NYSE, but with a three-year coolingoff period and dollar amounts limiting the reach of
disqualifications based upon compensation received.
Also, disqualification based upon a family member’s
employment would be limited to executive positions,
and disqualification based upon employment with the
company’s auditor would be limited to actually working
on the company’s audit. Pursuant to proposed amended
NASD Rule 4350(d)(2)(A)(i), a director who owns
more than 20% of the company’s outstanding securities
is not considered independent for purposes of
determining compliance with the requirement that the
audit committee be comprised solely of independent
directors (even though such director may be deemed
independent for other purposes). In light of Proposed
Rule 10A-3, it is unlikely that the NASDAQ proposal
would be approved by the SEC without substantial
revisions.
The AMEX summary of its proposed rule changes with
respect to independence appears essentially to
incorporate Proposed Rule 10A-3.
Kirkpatrick & Lockhart LLP
3
Bank & Thrift Regulatory UPDATE
FEBRUARY 2003
Financial Expert Requirements
Since 1998, Section 303.01 of the NYSE Manual has
required companies listed on the NYSE to have at least
one audit committee member who has “accounting or
related financial management expertise, as the Board of
Directors interprets such qualification in its business
judgment.” No amendment to this rule is currently
proposed. The NASDAQ proposal would replace the
current requirement in NASD Rule 4350(d)(2)(A) that
at least one member of the audit committee have
experience in finance or accounting with a requirement
that at least one member of the audit committee be a
financial expert, as defined in Sarbanes-Oxley and the
SEC’s implementing regulations. It is unclear from the
AMEX summary how the AMEX proposes to amend its
existing requirement that the chair of the audit
committee have “past employment experience in finance
or accounting, requisite professional certification in
accounting, or any other comparable experience or
background.”
of voting securities of that institution. The Guidelines
also provide that the board of directors of each insured
depository institution should determine annually
whether the members of the audit committee are
independent of management. The Guidelines further
provide that an individual or entity or controlling person
of such entity should be considered to be a “large
customer” for the independence requirement if the
board determines that such individual or entity has
relationships with the institution the termination of
which “likely would materially adversely affect the
institution’s financial condition or results of
operations.”
The Guidelines suggest that the boards of directors of
insured depository institutions (or their holding
companies) consider the following factors when
determining whether a director is independent:
n
whether the director is or has been employed by
the institution;
n
whether the director serves or served as a
consultant, advisor, promoter, underwriter, or
counsel of, or to, the institution or any of its
affiliates;
n
whether the director is a relative of an officer or
other employee of the institution or its affiliates;
n
whether the director holds or controls, or has held
or controlled, a direct or indirect financial interest
in the institution or its affiliates; and
n
whether the director has outstanding extensions of
credit from the institution or its affiliates.
CURRENT FDIC AUDIT COMMITTEE
REQUIREMENTS
All insured depository institutions with over $500
million of total assets are subject to the specific audit
committee requirements set forth in 12 C.F.R. Part 363
(“Part 363”), promulgated by the FDIC in 1992 under
Section 36 of the Federal Deposit Insurance Act,
12 U.S.C. § 1831m. Under Part 363, if an insured
depository institution is part of a holding company
structure and either has less than $5 billion in assets or
has a composite CAMEL rating of 1 or 2, the holding
company may comply with the requirements of Part 363
in lieu of the institution. If the depository institution or
holding company is publicly held, it also will be
required to comply with Sarbanes-Oxley and the
applicable Market Rules.
Independence Requirement
Part 363 requires that an audit committee must be
comprised solely of directors independent of
management and prohibits any large customer of an
insured depository institution with more than $3 billion
in assets from serving on the audit committee.
The Guidelines and Interpretations set forth in
Appendix A to Part 363 (the “Guidelines”) provide that
a director should be considered as not independent of
management if he or she is an officer or employee of the
depository institution or owns 10% or more of any class
4
Even if a director does not meet one or more of the
foregoing criteria, a board of directors may exercise
discretion and determine that the director is nevertheless
independent. By contrast, Sarbanes-Oxley and the
Market Rules disqualify any director who does not meet
each of the criteria for independence.
Financial Management Expertise Requirement
Insured depository institutions with more than $3 billion
in assets are also required under the Guidelines to have
at least two persons with “banking or related financial
management expertise” on their audit committees. A
person has such expertise for this purpose if the insured
depository institution’s board of directors determines
that he or she has significant executive, professional,
educational, or regulatory experience in financial,
auditing, accounting or banking matters.
BANK & THRIFT REGULATORY UPDATE
Bank & Thrift Regulatory UPDATE
FEBRUARY 2003
This requirement differs from the “audit committee
financial expert” requirement adopted by the SEC in
three significant respects. First, the Guidelines provide
an inclusive list of qualifications that is not limited to
accounting and finance, whereas the SEC rule limits
expert status to those with experience relating to
accounting or finance. Second, the Guidelines provide
that the board of directors of the institution is to
determine, based on very broadly stated considerations,
whether a director has the required expertise. By
comparison, the SEC rule requires a financial expert to
have very specific attributes. Third, while the SEC rule
merely mandates disclosure as to whether a financial
expert serves on the audit committee, Part 363 and the
Guidelines require two individuals meeting the broader
standards established under this Part to serve on the
audit committee.
RECOMMENDATIONS
Publicly held depository institutions and depository
institution holding companies should be cognizant of
the fact that they are subject not only to SarbanesOxley, relevant SEC regulations and the applicable
Market Rules, but are also subject to Part 363.
Depository institutions and depository institution
holding companies that are not publicly held should
nevertheless be aware of the concepts underlying
Sarbanes-Oxley, the SEC regulations, and the proposed
amendments to the Market Rules. The FDIC may
incorporate some of these same concepts into a revised
Part 363, which would continue to apply to all
depository institutions with over $500 million in total
assets.
To the extent that an insured depository institution not
subject to Sarbanes-Oxley is currently contemplating
changes in its audit committee membership, the
institution should consider complying with some or all
of the requirements of Sarbanes-Oxley, the SEC
regulations, and the Market Rules, even though they are
not directly applicable. Voluntary compliance may save
the institution the inconvenience and expense of having
to undo changes in the event that Part 363 is amended
so as to preclude service by a newly appointed audit
committee member. Moreover, depository institutions
may avoid the potential for regulatory or other criticism
with respect to their audit committee membership by
complying with standards applicable to publicly held
institutions.
More specifically, non-publicly held institutions should
consider including a financial expert on their audit
committees or, if it is impossible to include such an
expert, documenting the efforts taken to recruit such an
expert.
Kirkpatrick & Lockhart LLP
5
Bank & Thrift Regulatory UPDATE
FEBRUARY 2003
Kirkpatrick & Lockhart LLP has over 700 lawyers in 10 offices around the United States. Our Bank and Thrift
Regulatory practice is an important segment of the firm’s general financial services practice. That practice
extends to all major segments of the financial services industry, including investment managers, investment
advisers, investment banking, broker-dealers, mortgage bankers and custodians, as well as banks and thrifts.
Our Bank and Thrift Regulatory practice group provides legal advice primarily to depository institutions and
their holding companies, but also to various other clients with concerns relating to bank and/or thrift regulatory
matters. This advice covers all aspects of regulatory applications and analysis, mergers and acquisitions,
corporate reorganizations and developments with respect to specific financial products, particularly in the
lending, securities and insurance areas.
For more information about our Bank and Thrift Regulatory practice group’s capabilities, please contact one of
the attorneys listed below. Also, we invite you to visit our website at http://www.kl.com for more information
on our Bank and Thrift Regulatory practice group.
BOSTON
Stephen E. Moore
Stanley V. Ragalevsky
Sean P. Mahoney
617.951.9191
617.951.9203
617.951.3202
smoore@kl.com
sragalevsky@kl.com
smahoney@kl.com
HARRISBURG
Raymond P. Pepe
717.231.5988
rpepe@kl.com
LOS ANGELES
William P. Wade
310.552.5071
wwade@kl.com
NEW YORK
Robert M. McLaughlin 212.536.3924
Thomas C. Russler
212.536.4068
John D. Vaughan
212.536.4006
rmclaughlin@kl.com
trussler@kl.com
jvaughan@kl.com
PITTSBURGH
Kristen L. Stewart
J. Robert Van Kirk
412.355.8975
412.355.6480
kstewart@kl.com
rvankirk@kl.com
WASHINGTON
Henry L. Judy
Rebecca H. Laird
Dean E. Miller
Donald W. Smith
Ira L. Tannenbaum
Joseph P. Vitale
202.778.9032
202.778.9038
202.778.9371
202.778.9079
202.778.9350
202.778.9207
hjudy@kl.com
rlaird@kl.com
dmiller@kl.com
dsmith@kl.com
itannenbaum@kl.com
jvitale@kl.com
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© 2003 KIRKPATRICK & LOCKHART LLP.
ALL RIGHTS RESERVED.