SEC Adopts Standards Relating to Listed Company Audit Committees

Article by Mr David S. Rosenthal, Mr Martin Nussbaum and Mr Peter C. Bartolino

Summary

On April 9, 2003, the Securities and Exchange Commission (the "SEC") published final rules regarding standards for listed company audit committees, as directed by Section 301 of the Sarbanes-Oxley Act of 2002 ("SOX").¹ The new rules implement the requirements of Section 10A(m) of the Securities Exchange Act of 1934 (the "Exchange Act"), as added by Section 301 of SOX, and direct the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that is not in compliance with the audit committee requirements established by SOX.

Under the new rules, national securities exchanges and national securities associations (such as Nasdaq) will be prohibited from listing any security of an issuer that is not in compliance with the five standards that are set forth below.² The new rules allow such self-regulatory organizations ("SROs") flexibility to adopt and administer additional audit committee requirements through SRO rulemaking conducted under SEC oversight and approval. Because the new rules only affect issuers whose securities are listed on such SROs, issuers whose securities are quoted solely on the OTC Bulletin Board or the Pink Sheets are not affected by the new rules. The new rules apply 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.

It is important to note that although the new rules summarized below refer to matters relating to audit committees, neither the new rules nor SOX require that a company have an audit committee. Thus, if an issuer does not have a separate audit committee, then the entire board of directors of the issuer would be considered to be the audit committee for the purposes of the new rules, and the audit committee requirements set forth below would then apply to each board member and the board as a whole.³

Each member of the audit committee must be a member of the board of directors of the issuer, and must otherwise be independent. The new rules establish Section 10A(m)'s two criteria for audit committee member independence:

• Audit committee members may not accept directly or indirectly any consulting, advisory or compensatory fee from the issuer or any subsidiary thereof, other than in the member's capacity as a member of the board or any board committee.

• An audit committee member may not be an affiliated person of the issuer or any subsidiary thereof apart from the member’s capacity as a member of the board or any board committee. Venture capital and private equity investors, in particular, need to be mindful of this provision.

Unless the rules of the applicable SRO 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 issuer, provided that such compensation is not contingent in any way on continued service.

"Indirect acceptance" of a fee includes acceptance of such a fee by (1) a spouse, a minor child or stepchild or a child or stepchild sharing a home with the member or (2) an entity in which such member is a partner, member, an officer such as a managing director occupying a comparable position or executive officer, or occupies a similar position (except limited partners, non-managing members and those occupying similar positions who, in each case, have no active role in providing services to the entity) and which provides accounting, consulting, legal, investment banking or financial advisory services to the issuer or any subsidiary of the issuer.⁴

The rules define an "affiliated person" as a person who directly, or indirectly through one or more intermediaries, controls, is controlled by or is under common control with the issuer. An executive officer, employee-director, general partner or managing member of an affiliate will be deemed to be an affiliated person of the issuer. Whether a person is an affiliated person with respect to an issuer will be a factual determination based on all facts and circumstances. Nevertheless, under a non-exclusive safe harbor provision, a person would not be deemed an affiliated person if he or she:

• is not a beneficial owner, directly or indirectly, of more than 10% of any class of voting equity securities of the issuer; and

• is not an executive officer of the issuer.⁵

There is an exemption from the independence requirements for companies becoming listed issuers for the first time. Such issuers must have at least one independent audit committee member as of initial listing (i.e., effective date of the issuer’s initial registration statement under Section 12 of the Exchange Act or registration statement under the Securities Act of 1933 covering an initial public offering of securities of the issuer), a majority of independent members within 90 days and a fully independent audit committee within one year.

The audit committee of each issuer, 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 any registered public accounting firm engaged (including resolution of disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report 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. While the practice has yet to evolve, the obligation of the audit committee in these areas—appointment, compensation, retention and oversight—is undoubtedly greater. Without superseding the obligations and role of management, audit committees will be required to play a more active role as a committee and exhibit greater awareness of the auditor’s responsibilities and activities. For example, in determining the auditor’s fees, the audit committee needs to engage in a more active dialogue with the auditor (and management) about the fees and the scope of the work to be performed therefor.

The instructions to the new rules clarify that the rules do not conflict with, and do not affect the application of, any provision of an issuer's governing law or documents or other home country legal or listing standards that require or permit shareholders to ultimately vote on, approve or ratify the selection of the issuer’s auditor. The requirements instead relate to the assignment of responsibility as between the audit committee and management. For instance, if an issuer’s organizational documents state that the issuer’s auditors must be elected by the issuer’s shareholders, the audit committee of the issuer, not management, must be responsible for making the recommendation or nomination of the auditors to the shareholders.⁷

Each audit committee must 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.

The SEC did not mandate the establishment of specific procedures but instead expects each issuer’s audit

committee to develop procedures applicable to such issuer’s particular circumstances.

Each audit committee must have the authority to engage independent counsel and other advisers, as it determines necessary to carry out its duties.

Each issuer must provide for appropriate funding, as determined by the audit committee, in its capacity as a committee of the board of directors, for payment of:

• compensation to any registered public accounting firm engaged for the purpose of rendering or issuing an audit report or performing other audit, review or attest services for the issuer;

• compensation to any advisers employed by the audit committee; and

• ordinary administrative expenses of the audit committee that are necessary or appropriate in carrying out its duties.

The new rules will apply to both domestic issuers and foreign private issuers. Several provisions, applicable only to foreign private issuers,⁸ have been included that seek to address the special circumstances of particular foreign jurisdictions. These provisions include:

• allowing non-management employees to serve as audit committee members, consistent with "codetermination" and similar requirements in some countries;

• allowing shareholders to select or ratify the selection of auditors, also consistent with requirements in many foreign countries;

• allowing alternative structures such as statutory auditors to perform auditor oversight functions where such structures are provided for under local law; and

• addressing the issue of foreign government shareholder representation on audit committees.

The new rules make several updates to the SEC’s disclosure requirements regarding audit committees. Issuers are now required to state in their annual reports on Form 10-K or 10-KSB (or a proxy statement or information statement pursuant to the Exchange Act if action is to be taken with respect to the election of directors) whether or not the issuer has a separately-designated standing audit committee or a committee performing similar functions. If the issuer has such a committee, each member must be identified, and if the issuer’s entire board of directors is acting as the issuer’s audit committee, such fact must be specifically stated. In addition, if an issuer relies on an exemption from the audit committee standards, the issuer must disclose such reliance and provide 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 audit committee standards.⁹

Because the Exchange Act now provides that in the absence of an audit committee the entire board of directors will be considered to be the audit committee, the new rules clarify that if the issuer does not have a separately designated audit committee, or committee performing similar functions, the issuer must provide the disclosure with respect to all members of its board of directors.

The SEC voted to establish two sets of implementation dates for issuers. Generally, issuers will be required to comply with the new listing rules by the date of their first annual shareholders meetings after January 15, 2004, but in any event no later than October 31, 2004. Foreign private issuers and small business issuers will be required to comply by July 31, 2005.¹⁰