E-NEWS ALERT
March 17, 2003
SEC Proposed Rules Regarding Audit Committee Standards
for Listed Companies
Complying with the congressional mandate of Section 301 of the Sarbanes-Oxley Act of 2002,1
the Securities and Exchange Commission (the “SEC”) recently proposed a new rule directing the
national securities exchanges and national securities associations (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.2 The
requirements relate to:
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The independence of audit committee members;
The audit committee’s responsibility to select and oversee the issuer’s independent
accountants;
The audit committee’s responsibility to establish procedures for handling complaints
regarding the issuer’s accounting practices;
The authority of the audit committee to engage independent counsel and other advisors;
and
The issuer’s obligation to fund the independent auditor and any outside advisors engaged
by the audit committee.
The effect of Section 301 of Sarbanes Oxley is to enlarge the role of the audit committee,
significantly expanding its function and responsibilities as compared to past practices and
requirements. Historically the audit committee’s obligation to seek out information was limited,
and its responsibility to discuss financial statements with management and auditors was imposed
through disclosure rules, rather than by direct fiat.3 The new rules, in addition to disclosure
requirements, impose the substantive requirements listed above through the listing rules of the
SROs, which must de-list any company that does not comply. The SROs are free to establish
more restrictive requirements than those proposed by the SEC.
1
Section 301 of Sarbanes-Oxley added new Section 10A(m) to the Securities and Exchange Act of 1934. For the full
text of the Sarbanes-Oxley Act, see http://news.findlaw.com/hdocs/docs/gwbush/sarbanesoxley072302.pdf.
2
See 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. The SEC must issue its final
rule by April 26, 2003. Under the proposals, the new requirements would need to be operative by the national
securities exchanges and national securities associations no later than the first anniversary of the publication of the
final rule in the Federal Register.
3
In 1999, the SEC promulgated a number of rules requiring disclosures in annual reports and proxy statements
regarding audit committees. See Final Rule: Audit Committee Disclosure, Exchange Act Rel. No. 34-42266,
http://www.sec.gov/rules/final/34-42266.htm, amending Rule 10-01 of Regulation S-X, Item 310 of Regulation S-B,
Item 7 of Schedule 14A, and Item 302 of Regulation S-K, and adopting new Item 306 of Regulation S-K and Item
306 of Regulation S-B.
Questions Relating to the Proposed Rule
Which companies must comply with the new audit committee rule?
The rule only applies to companies listed on a national securities exchange or an automated
inter-dealer quotation system of a national securities association. Thus the rule would not apply
to companies that have become reporting companies due to issuances of debt or other securities
that are not listed on an exchange, or companies that have securities traded over-the-counter,
such as on the OTC Bulletin Board or similar facilities. 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 SEC
proposes a 90-day grace period from the date of the initial Securities Act or Exchange Act
registration statement relating to an initial public offering, during which period one member of
the issuer’s audit committee would be exempt from the independence requirements. However,
neither the NYSE’s or Nasdaq’s current proposed rules would recognize a grace period.
Reporting companies that are not listed by SROs will still be subject to the audit committee
disclosure rules promulgated in 1999. In addition, the new proposal includes a proposed
amendment to Schedule 14A that would require a non-listed reporting company to report in its
proxy statement whether or not it has an audit committee established in accordance with Section
3(a)(58)(A) of the Exchange Act and if so, whether the members of the committee are
independent.
What is an audit committee?
Section 3(a)(58) of the Exchange Act, as added by Section 205 of Sarbanes Oxley, defines audit
committee as a committee established by the board of directors of an issuer for the purpose of
overseeing the accounting and financial reporting processes of the issuer and audits of the
financial statements of the issuer. If no audit committee has been establishedthe 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.
What constitutes “independence”?
To satisfy the independence requirement an audit committee member may not (1) receive any
kind of payment from the company other than in the member’s capacity as a director and
member of the committee, or (2) be an affiliate of the company or its subsidiary.4
What types of payments violate the independence requirement?
4
“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 the issuer. The proposed rule specifically states that directors,
executive officers, partners, members, principals or designees of an affiliate would be affiliates. Whether substantial
shareholders are “control persons” has traditionally been a more difficult fact-based assessment. In light of this
difficulty the SEC has proposed a safe harbor -- a person who is not an executive officer, director or beneficial
owner of more than 10% of any class of equity securities of the issuer would be deemed not to be a control person
and therefore not an affiliate.
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 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 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. Independence would not be precluded solely on the basis of a relationship in the
ordinary course of business.5
What are the increased responsibilities with respect to oversight of the auditing process?
To a significant extent the proposed rule would shift management of the independent audit
process from company management to the audit committee. Under the 1999 disclosure rules and
past practice, the audit committee’s role was primarily one of review and oversight. The 1999
rules (which are still in effect for all reporting companies) require the audit committee to
disclose, among other things, (1) whether it reviewed and discussed the financial statements with
management, (2) whether it discussed with the independent auditors certain matters relating to
the conduct, scope and results of the audit, and (3) whether the committee had any discussions or
disclosures with the auditors regarding the auditors’ independence. The audit committee’s
obligation to seek out information was limited and there was generally no requirement to
establish procedures to capture information.
The audit committee must appoint and manage the auditors.
Under the proposed rule, the audit committee of each issuer must be directly responsible for the
appointment, compensation, retention and oversight of the work of any registered public
accounting firm 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.6 Each such registered public
accounting firm must report directly to the audit committee. The rule makes it clear that
determination of payment for the independent auditors is the audit committee’s function, and the
issuer is required to appropriate funds as determined by the committee.
The proposed rule is intended to relate to the allocation of responsibility between the audit
committee and management. The rule includes provisions to clarify that it would not preempt
corporate charter provisions or, in the case of foreign companies, home country requirements
that provide for shareholders to elect or ratify the selection of auditors. In these cases the audit
committee would be responsible for making any necessary recommendations or nominations.
5
For example, if an audit committee member of an issuer were an officer of a company that provides office supplies
to the issuer, that relationship alone would not violate the independence requirement. Comments of Martin Dunn,
Deputy Director, SEC Division of Corporation Finance, given February 22, 2003 at the 23rd Annual Northwest
Securities Institute, Vancouver B.C.
6
In selecting an auditor, the audit committee must be conscious of the new requirements with respect to auditor
independence set forth in Sections 201 through 209 of Sarbanes-Oxley and the final rules that have been published
with respect thereto. See Final Rule: Strengthening the Commission's Requirements Regarding Auditor
Independence, Release Nos. 33-8183; 34-47265, 35-27642, http://www.sec.gov/rules/final/33-8183.htm.
The audit committee must establish procedures for handling complaints.
The proposed rule places an affirmative obligation on the audit committee to handle complaints.
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 submission by employees of the issuer of concerns
regarding questionable accounting or auditing matters.7 The proposal stops short of
recommending or mandating specific procedures. The SEC believes issuers should have
flexibility to develop procedures appropriate to their circumstances. However, this should not be
understood to be a license to establish vague or ineffectual procedures. The term “treatment”
implies that implemented procedures must adequately address and follow-through with filed
complaints.
The audit committee may hire its own advisors, which the company must fund.
The SEC recognizes that the management duties imposed by the new rules may tax the limited
resources of audit committee members themselves. The committee may need expert assistance
in accounting, financial reporting or legal matters. Accordingly, the proposed rule would
specifically require the audit committee to be given authority to engage outside advisors,
including legal counsel, as it determines necessary to carry out its duties.
The authority to appoint advisors would be eviscerated and the independence of the committee
compromised if the committee has no authority to pay those advisors. Accordingly, the proposed
rule would require the issuer to provide for appropriate funding to compensate its advisors, as
determined by the audit committee.
Are there any exceptions or exemptions to the new requirements?
Foreign Issuers. A number of foreign countries have rules relating to the audit process that
conflict with the proposed rule. To address these concerns the proposed rule has special
provisions for foreign issuers which, if certain conditions are met, allow non-management
employees, representatives of shareholder groups, and government representatives to sit on the
audit committee where required by home country rules. Further exemptions relate to those
countries which provide auditor oversight through statutory auditors or special boards of
auditors. Foreign private issuers subject to the audit committe rules would be exempt from the
requirements regarding the independence of audit committee members and the audit committee’s
responsibility to oversee the work of the outside auditors.
Other Exemptions. Issuers of futures, standardized options, and asset-backed securities, and
exchange-traded unit investment trusts (UITs) are excluded from the proposed requirements;
however, closed-end investment companies and exchange-traded open-end investment
7
Although proposed Rule 301 and the SRO listing requirements are not yet effective, we believe companies
required to file reports with the SEC should adopt whistleblower policies now. Our rationale is that Section 806 of
Sarbanes-Oxley, which is now in effect, creates a remedy for employees against whom retaliatory action is taken for
certain whistle blowing activities. Policies that protect against liability under Section 806 would, in large part, be
the same ones that would satisfy the complaint procedure requirements of Section 301. See
http://www.prestongates.com/publications/alert.asp?pubID=354.
companies are not. The proposed rule did not provide any special rules for small businesses.
Recognizing the constraints faced by many of these issuers the SEC sought comment on this
topic.
How have disclosure requirements for issuers increased?
In addition to the disclosure requirements imposed by the 1999 rules, a listed issuer would have
to disclose in its annual reports and proxy statements:
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the members of the audit committee;
whether the members are independent;
whether the issuer 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; and
that the entire board is the audit committee, if none has been separately designated.
When will the requirements be effective?
The Act requires the SEC to issue its final rules by April 26, 2003. Listed companies will be
subject to the SRO rules within one year after the final rule is published in the Federal Register.