Securities Legal Alert - SEC Issues Final Rules on Audit Committee Standards

Overview

Section 301 of the Sarbanes-Oxley Act of 2002 prohibits national securities exchanges and national securities associations from listing companies that are not in compliance with the following requirements:

• each member of the audit committee must be "independent", as defined pursuant to the Act;

• the audit committee must be directly responsible for the appointment, compensation, retention and oversight of the work of the listed company’s auditor, and the auditor must report directly to the audit committee;

• the 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 listed company 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 listed company must provide appropriate funding for the audit committee.

The SEC has now issued final rules implementing these provisions, and which also clarify and expand upon the requirements of Section 301. The rules will apply to issuers that have any securities (not only voting equity securities) listed on any national securities exchange or through a national securities association.

Under Section 301 of the Act, a member of a listed company’s audit committee is not independent if he or she (a) accepts, directly or indirectly, any consulting, advisory or other compensatory fee from the listed company, other than in his or her capacity as a member of the board of directors or a board committee; or (b) is an "affiliated person" of the listed company.

Under the SEC’s final rules, the prohibition against accepting any compensatory fee includes the acceptance of such a fee by an entity (a) in which the director is a partner or member or occupies a similar position, (other than where the director has no active role in providing services to the entity), and (b) that provides accounting, consulting, legal, investment banking, financial or other advisory services to the listed company. It also generally precludes the acceptance of such a fee by a spouse or minor children of a director. The rules do not contain either a de minimus exception or an exception for "limited and exceptional circumstances", as currently provided under existing Nasdaq rules.

The prohibition on compensatory fees will not, however, preclude other ordinary course commercial relationships between a listed company and an entity with which a director has a relationship, although certain such relationships may be prohibited under rules proposed by the various stock exchanges. In addition, the prohibitions only apply to current relationships and do not include a "look back" period, as is contemplated under separate rules proposed by the various stock exchanges.

The prohibition on compensatory fees will not include 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.

Under the rules, an "affiliated person" is defined consistent with the definition of "affiliate" under existing federal securities laws -- i.e., as a person who directly, or indirectly through one or more intermediaries, controls, is controlled by, or is under common control with the listed company. "Control" as used in the rules is defined 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 rules include a safe harbor for the absence of "control". A person will be deemed not to "control" a company if the person is not the beneficial owner, directly or indirectly, of more than 10% of any class of equity securities of the company and is not an executive officer of the company. Outside the safe harbor, a listed company may still establish that an audit committee member is not an affiliated person based on a facts and circumstances analysis.

However, under the rules, executive officers, directors who are also employees of an affiliate, and general partners and managing members of an affiliate will automatically be deemed to be affiliates.

The final rules contain two exemptions from the independence rules:

• newly listed companies will not immediately be required to comply with the independence requirements; instead, a newly public company’s audit committee must have one fully independent member at the time of the company’s initial listing, a majority of independent members within 90 days of initial listing, and a fully independent audit committee within one year of initial listing.

• an audit committee member may sit on the board of directors of a listed company and any affiliate of that company so long as, except for serving on such boards, the member otherwise meets the independence requirements for each such entity, including the receipt of only ordinary course compensation for serving as a member of the board of directors, audit committee or other board committee of each such entity.

A listed company availing itself of one of these exemptions must disclose that fact in its annual report and proxy statement, and provide the company’s assessment of how, if at all, such reliance materially and adversely affects the ability of the audit committee to act independently and perform its duties.

The rules also provide a limited exception for audit committee members who cease to be independent for reasons outside the member’s reasonable control. The SEC referenced one such potential situation as where an audit committee member is a partner in a law firm that provides no services to the listed company on which the member sits, but the listed company later acquires another company that is a client of the member’s law firm. In these types of limited circumstances, the audit committee member, with notice by the listed company to the applicable national securities exchange or association, could remain an audit committee member of the listed company until the earlier of the next annual meeting of the listed company or one year from the occurrence of the event that caused the member to lose his or her independence.

The final rule regarding the authority of audit committees with respect to independent auditors provides that the audit committee of each listed company, in its capacity as a committee of the board of directors, must be directly responsible for the appointment, compensation, retention and oversight of the work of the listed company’s auditors (including resolution of disagreements between management and the auditor regarding financial reporting), and the auditors must report directly to the audit committee.

The SEC indicated that this requirement does not conflict with, and will not be affected by, any requirement that a listed company’s shareholders elect, approve or ratify the selection of the listed company’s auditor. If the listed company provides a recommendation or nomination for an auditor to its shareholders, the audit committee of the listed company will be responsible for making such recommendation or nomination.

The final rule regarding the establishment of procedures for complaints provides that an audit committee of a listed company must establish procedures for:

• the receipt, retention, and treatment of complaints received by the company regarding accounting, internal accounting controls or auditing matters; and

• the confidential, anonymous submission by employees of concerns regarding questionable accounting or auditing matters.

The rules do not establish specific procedures for audit committees to follow; instead, the SEC emphasized that each company should have the flexibility to establish procedures that are most appropriate for the company’s individual circumstances.

Under the final rules, an audit committee of a listed company must have the authority to engage independent counsel and other advisors as it determines necessary to carry out its duties. The SEC emphasized that such outside advisors can help educate audit committees on standards employed by audit committees of other comparable public companies.

The rules also mandate that each listed company must provide appropriate funding, as determined by the audit committee, for payment of compensation to the listed company’s auditors and to any advisors employed by the audit committee. A listed company must also provide appropriate funding for the ordinary administrative expenses of the audit committee that are necessary or appropriate for carrying out its duties.

Under the final rules, each listed company will be required to promptly notify the national securities exchange or association when any executive officer of the listed company becomes aware of a material noncompliance with the audit committee requirements. The rule contemplates, however, that listed companies will have an opportunity, presumably in accordance with existing delisting procedures of each national securities exchange or association, to cure any defects before delisting would be mandated.

Each national securities exchange and association must provide to the SEC no later than July 15, 2003 proposed rules or rule amendments that comply with the requirements of the final rules. The final rules must be approved by the SEC no later than December 1, 2003. Each listed company (other than small business issuers) must be in compliance with the new listing rules by the earlier of (a) its first annual shareholders meeting after January 15, 2004, or (b) October 31, 2004. Listed companies that are small business issuers will have until July 31, 2005 to comply with the new listing rules.

The New York Stock Exchange, Nasdaq and the American Stock Exchange all have proposals for changes in their listing criteria pending before the SEC that purport to address the requirements of the rules, although all were submitted before the SEC rules became final.

© Kilpatrick Stockton LLP