New York State Bar Association
Business Law Section
February 28, 2003
Securities and Exchange Commission
Attention: Jonathan G. Katz, Secretary
Ladies and Gentlemen:
The Committee on Securities Regulation (the "Committee") of the Business Law Section of the New York State Bar Association appreciates the invitation in Release No. 33-8173 (the "Release") to comment on the proposed new rule directing national securities exchanges and securities associations to prohibit listing securities of any issuer that is not in compliance with certain audit committee standards, and related revisions to the audit committee disclosure requirements.
The Committee is composed of members of the New York Bar, a principal part of whose practice is in securities regulation. The Committee includes lawyers in private practice and in corporation law departments. A draft of this letter was reviewed by certain members of the Committee, and the views expressed in this letter are generally consistent with those of the majority of members who reviewed and commented on the letter in draft form. The views set forth in this letter, however, are those of the Committee and do not necessarily reflect the views of the organizations with which its members are associated, the New York State Bar Association, or its Business Law Section.
The Release proposes a new rule (the "Rule") which would implement the audit committee listing requirements of Section 10A(m) of the Exchange Act as added by Section 301 of the Sarbanes-Oxley Act of 2002, and also proposes changes in the current disclosure requirements regarding audit committees.
A. Summary Of Comments
The Committee supports the Commission's goals to promote effective and independent audit committees, and also generally supports the proposed Rule on listing requirements for audit committees, and the related disclosure requirements. However, we recommend that the Commission make certain changes in the proposed Rule set forth in this letter, which we believe would further those goals without compromising the independence and effectiveness of audit committees.
The proposed Rule would limit or prohibit significant shareholders from being represented on audit committee in certain circumstances. One of our major concerns is with the limitation this places on the ability of significant shareholders to exercise their responsibilities, obligations and oversight with respect to the companies they invest in. To meet this concern we urge the Commission to increase the ownership threshold in the safe harbor from 10% to 20% of voting common stock, and to expand the exemption from the Rule for consolidated, majority-owned subsidiaries by eliminating the requirements for majority ownership if the subsidiary is consolidated, and for the parent to have a class of common equity listed so long as the parent is a listed company. Where a consolidated subsidiary is subject to the Rule because it has equity listed, we recommend an exemption permitting representatives of the parent who are otherwise independent of the subsidiary to be on the subsidiary's audit committee as long as such representatives do not constitute a majority of the committee.
In addition, we recommend that the exemption allowing an outside director to be on the audit committees of a company and of its consolidated, majority-owned subsidiary if the director is otherwise independent of the subsidiary, be expanded to also apply to unconsolidated and less-than-majority-owned affiliates. We would also permit more than one outside director under that exemption so long as such directors in the aggregate do not constitute a majority of the audit committee.
We also recommend broadening the proposed exemption following an initial public offering from 90 days to one year and permitting more than one member as long as audit committee members relying on the exemption do not constitute a majority of the committee.
Similarly, we recommend enlarging the exemption for more-than-50% shareholders of foreign private issuers to permit full membership on the audit committee instead of a non-voting observer position, applying the exemption to any shareholders whether or not they own more than 50% of the voting common stock, and permitting more than one representative as long as the persons relying on the exemption do not constitute a majority of the committee.
We believe that the proposed effective date of the first anniversary of publication of the Commission's final Rule in the Federal Register will not provide sufficient time for companies to come into compliance. We urge the Commission to establish an effective date for compliance that would allow each company until its first annual meeting of shareholders or other shareholder meeting at which directors are elected following the first anniversary of approval of the applicable securities exchange or association rules, plus 30 days. This would insure that each company would have at least one year after the final exchange or association rules are approved and known to hold a shareholders' meeting and come into compliance.
We also ask that the Commission clarify that compensation under retirement or deferred compensation or similar plans do not constitute disqualifying compensatory fees, establish a $60,000 annual de minimus exception for fees received, and clarify that being a director does not disqualify a director as an affiliated person of the issuer under the definition of independence. We believe that the determination of independence of audit committee members where judgment is required should be made by the board of directors. Finally, we recommend that the Commission not require that the audit committee be responsible for the internal auditor without further study of the issue, and that the Commission consider future requests for exemptions or waivers regarding home country requirements and practices for foreign private issuers.
B. The Commission Should Increase The Ownership Percentage Test In The Proposed Safe Harbor From 10% to 20%
To meet the independence requirements to be a member of an audit committee under the proposed Rule, a director may not accept consulting, advisory or other compensatory fees from the issuer (other than compensation as a director), and may not be an affiliated person of the issuer or any subsidiary of the issuer. The Rule uses the traditional control test to define affiliate. A director, executive officer, partner, member, principal or designee of a controlling shareholder and affiliate of an issuer will be deemed to be an affiliate of the issuer.
The Rule proposes a safe harbor from being a control person and affiliate of an issuer for a person who is not: (i) an executive officer; (ii) a director (presumably this does not apply to the independence of a director to serve on the issuer's audit committee), or (iii) the beneficial owner, directly or indirectly, of more than 10% of any class of equity securities, of the issuer. This safe harbor will provide useful certainty in determining compliance with the independence requirements of the proposed Rule for serving on an issuer's audit committee. However, the Release requests comments on whether the threshold should be higher or lower than 10%.
We have concerns about the 10% threshold, both with respect to the lack of consensus as to what percentage ownership (and under what circumstances) constitutes control, and as to the requirement for determining the amount of beneficial ownership in accordance with Exchange Act Rule 13d-3(d)(1). To avoid these concerns, we recommend that the Commission adopt a 20% threshold for the safe harbor provision in the final Rule.
The Release points out that exceeding the 10% threshold of the safe harbor does not deem a person to be affiliated with the issuer and thereby not independent. Therefore, it would still be possible to make a factual determination that a director is not a control person based on a facts and circumstances analysis. However, in light of the uncertainty inherent in making such a determination, the serious consequences if the determination is found to be incorrect, and the publicity surrounding audit committee composition and compliance, we expect that issuers will rely on a facts and circumstances analysis only rarely. As a practical matter, the safe harbor threshold will be the test to determine whether a shareholder can have representation on the audit committee.
For safe harbor purposes, beneficial ownership of equity securities by a shareholder will be attributed to a director of the issuer who is a director, executive officer, partner, member or principal of the shareholder or has been designated by the shareholder. In addition, under Rule 13d-3 beneficial ownership includes shares where the shareholder has, or shares, directly or indirectly, the power to vote or the power to dispose, as well as shares of other members of a reporting group. This is a very expansive definition of ownership given the concepts of "sharing," "indirectly" and "groups." The Rule 13d-3 definition of beneficial ownership is used as a trigger for reporting purposes, and would tend to exaggerate whether there is, and the extent of, control by the shareholder.
Finally, we believe that the threshold should be based on percentage ownership of voting power, not on percentage ownership of any class of equity. Therefore, the threshold should be based on ownership of voting common stock. Rule 13d-3(d)(1) already takes into account the effects of options, warrants, other rights and convertible securities in determining beneficial ownership of a security.
In establishing the appropriate threshold for the safe harbor it is necessary to balance the severe consequences that exceeding the safe harbor threshold has for a shareholder's ability to meet its obligations and responsibilities with respect to investments in listed companies, the expansive definition of ownership and the extensive disclosure surrounding the relationship of audit committee members to an issuer, with the possibility of compromising the independence and effectiveness of the audit committee. On balance, we believe that 10% is too low, and urge that the Commission establish 20% ownership of voting common equity as the threshold for the safe harbor in the final Rule.
C. The Proposed Exemptions From the Rule For Majority-Owned Consolidated Subsidiaries And From Disqualification To Serve On Audit Committees Because Of Certain Share Ownership Should Be Expanded
We support the proposed exemptions from the Rule for certain consolidated, majority-owned subsidiaries, and from disqualification to serve on audit committees because of share ownership which would allow shareholder representation on audit committees in certain limited cases. However, we urge the Commission to broaden these exemptions as recommended below, which we believe is consistent with the public interest and the objectives of Sarbanes-Oxley.
Because share ownership of 10% or less in a company does not disqualify a person from being independent for audit committee purposes under the proposed safe harbor provision, the discussion in this Section covers only share ownership of more than 10%. In Section B above we urge the Commission to increase the threshold under the proposed safe harbor from 10% to 20%. Although we have retained the reference to the currently proposed 10% threshold level in our discussion in this Section, we believe that the threshold should be increased to 20%, and that the analysis and conclusions in this Section apply equally with a 20% threshold.
The following is a summary of the effect of the proposed exemptions for stock ownership of more than 10% of companies ("Investees") in several relevant circumstances.
In addition to the above exemptions, the proposed Rule would provide special exemptions for foreign private issuers, and a limited exemption in the case of an IPO discussed in Section D below. Also, where a director is not within the proposed safe harbor or one of the above exemptions because of equity ownership, it may be possible to claim that a director is not in a control relationship based on a facts and circumstances analysis. However, in light of the difficulties in making a control determination and other factors discussed in Section B above, we would not expect widespread use of that approach.
Our major concern is with the limitations on the ability of significant shareholders to be represented on audit committees of the Investee companies they invest in.
The corporate structure used by some entities in which some or all debt financing is provided through consolidated, controlled subsidiaries is identified in the Release. The Commission correctly recognizes the valid need and requirement for the Parent company to control the financial operations of the consolidated subsidiary in such a case. We strongly support the proposed exemption of the consolidated subsidiary from the requirements of Rule. In addition, we agree with the condition for the complete exemption from the Rule that the subsidiary not have any class of equity listed other than non-convertible, non-participating preferred. Where the consolidated subsidiary has such equity listed, we believe that a more limited exemption should be available as discussed in Subsection 2 below.
In addition, the proposal would condition the exemption not only on the Investee company being a consolidated subsidiary, but also on the Parent having majority ownership. As long as the Investee company is consolidated in the financial statements of the Parent, there is no need for the further requirement that the Parent have majority ownership. For example, there are joint ventures in which no participant has majority ownership, but where accounting rules would require consolidation. We would expect that there will be additional structures in which consolidation is required even though there is no majority ownership, under the interpretation governing Consolidation of Variable Interest Entities recently adopted by the Financial Accounting Standards Board.1
In all such cases, the rationale given in the Release for the exemption would apply -- subjecting the subsidiary to the proposed Rule would add little additional benefit if the subsidiary is closely controlled by a parent issuer subject to the Rule and could create an onerous burden on the Parent to recruit and maintain an audit committee meeting the requirements for each subsidiary.
Furthermore, subjecting the consolidated entity to the audit committee requirements of the proposed Rule would have the effect of limiting the Parent's ability to exercise its critical decision-making responsibilities relating to the auditing, accounting and financial reporting process of the consolidated entity. Those decisions could have a material impact on the financial operations and financial reporting of the Parent.
We urge the Commission to eliminate the majority ownership condition of the proposed exemption where the entity is consolidated in the financial statements of the Parent.
In addition, the proposed Rule would condition the exemption on the Parent having a class of common equity securities listed with a SRO subject to the Rule. While we agree that the exemption should be conditioned on the Parent being subject to the Rule by reason of having a class of securities listed with a SRO, we can see no valid reason why that has to be a class of common equity. The Release gives no rationale for denying the exemption if common equity is not listed.
The Commission also conditions the separate exemption for multiple listings on a company having a class of common equity listed, with which we disagree. In that context, the rationale given in the Release is that the listing of a class of common equity would most likely represent the primary public listing of the company. That is not a reason to deny the exemption in that case or here. The Parent will be equally subject to the Rule whether it has common equity listed or only debt listed. In fact, it is likely that if the Parent also had common equity listed it would be listed with a SRO on which its debt is listed. Finally, the need and requirement for the Parent to control the financial operations of the consolidated subsidiary are equally compelling whether or not the Parent has a class of common equity listed. Accordingly, the exemption for consolidated subsidiaries should apply if the Parent has any class of securities listed with a SRO subject to the Rule.
We do not object to the provision that the complete exemption from the requirements of the proposed Rule should not apply where the consolidated subsidiary has listed a class of equity other than non-convertible, non-participating preferred. Although the obligations and responsibilities of the Parent with respect to the subsidiary's financial statements remain the same as when debt but no equity is listed, in this case there are equity holders of the Investee who represent a new, substantially different constituency than debtholders. However, even though the subsidiary will be subject to the Rule, in our view this does not mean that the Parent should be barred from having any representation on the audit committee.
The only proposed exemption that would apply where the subsidiary has common equity listed is that an outside director of the Parent can be on the audit committees of both the Parent and the subsidiary where the director is otherwise independent to both companies. However, we believe that is much too narrow an exemption for a Parent controlling shareholder of a consolidated subsidiary.
We recommend that the final Rule provide an exemption to permit representatives of controlling Parents of consolidated subsidiaries subject to the Rule to serve on the audit committee of the subsidiary as long as the representative is otherwise independent of the subsidiary, the Parent is a listed company subject to the Rule, and the Parent's representatives relying on the exemption do not in the aggregate constitute a majority of the audit committee. Furthermore, this exemption should apply to consolidated subsidiaries whether or not the Parent is a majority owner, and whether or not the Parent has common equity listed as long as the Parent is a listed company subject to the Rule
For purposes of determining the majority of independent directors under this exemption and the exemption discussed in Subsection 3 below, we would consider together directors under such exemptions plus directors qualifying under any other exemption that is also conditioned on a majority of the audit committee members being independent without relying on that exemption.
Without our proposed exemption, the Parent of a consolidated subsidiary with equity listed could not effectively carry out its critical decision-making responsibilities relating to the subsidiary (such as hiring and firing auditors and the resolution of disputes between subsidiary management and the outside auditors) if the subsidiary has listed equity other than non-convertible, non-participating preferred. The other shareholders of the subsidiary would also be deprived of the benefit of the knowledge and experience that the Parent and its representatives can contribute to the subsidiary's audit committee process.
We believe that the absence of an exemption permitting participation by representatives of a controlling Parent shareholder on a subsidiary's audit committee would deprive the Parent of significant rights to which it should be entitled under both state and federal corporate governance and disclosure principles, as well as under federal securities laws. In accordance with traditional fiduciary duty and other obligations under state law principles, it is likely that the shareholders of both the Parent and the subsidiary would expect the Parent to exercise significant control over the business, affairs and operations of the subsidiary.
Furthermore, the exclusion of the Parent from effective participation in the audit committee process of a controlled subsidiary would appear at odds with the responsibilities imposed upon the Parent by the securities laws. For example, in some circumstances the controlling Parent may be responsible under securities laws for disclosures (and conduct) involving itself and its subsidiaries.
Finally, we believe that the exemption should include all directors, executive officers, partners, members, principals and designees of the Parent who are otherwise independent of the subsidiary. We do not believe that the independence and integrity of the subsidiary's audit committee would be compromised because such representatives would not be executive officers of the subsidiary, would receive only ordinary-course compensation from the subsidiary for serving as a member of the board, audit committee or other board committees of the subsidiary, and in the aggregate would not constitute a majority of the audit committee. Furthermore, any financial impact on the Parent's reported financial results of the subsidiary's operations and accounting treatment would be subject to the oversight of the Parent's independent audit committee which itself would be subject to the Rule as a listed company.
The Commission correctly recognizes the legitimate need of a listed company to have representation on the audit committee of a consolidated, majority-owned subsidiary, and proposes a narrow exemption. The exemption would permit a member of the Parent's audit committee to also be on the subsidiary's audit committee, assuming the director is otherwise independent with respect to both companies.
We support this exemption, although we believe that it should apply whether or not the affiliated company is consolidated, and where there is less than majority ownership. The Commission's conclusion that an independent director's serving on the board of a controlled subsidiary should not adversely affect the director's independence (Release, p. 8) would appear to apply equally to serving on the board of an unconsolidated affiliate or an affiliated company with less than majority ownership. In both cases, the director would receive only ordinary-course compensation for serving as a member of the board, audit committee or other board committee of the Parent and the affiliated company, would not be an executive officer of the affiliated company, and presumably would not be an executive officer of the Parent.
We believe that the exemptions we have proposed above are in the public interest and consistent with the Congressional mandate that audit committees be independent of management. We understand management to consist of the officers and senior employees of an entity, and agree that an adequate system of checks and balances requires that certain financial determinations, such as the selection of auditors, be made by the directors rather than by management, and that the oversight of auditing, accounting and financial reporting be performed in a context independent of management. Because it is the shareholders' interest that is being served by the audit committee independence requirements, the automatic exclusion of shareholders and their representatives from the audit committee does not appear required by Sarbanes-Oxley or the public interest. We believe that the exemptions proposed by the Commission with the changes we have proposed above will provide for effective and independent audit committees.
D. The IPO Exemption To The Audit Committee Independence Requirements Should Apply For One Year And Should Not Be Limited To One Director Where A Majority Of The Audit Committee Is Independent
We agree with the Commission about the need for an exemption in the case of a company coming to market with its initial public offering ("IPO"). The Release specifically requests comments on whether the exemption should be longer than 90 days and apply to more than the one director, as provided in the proposed Rule.
We believe that 90 days is inadequate, and that the exemption should be for one year. For example, in the case of a spin-off of a division or subsidiary to shareholders, an IPO often precedes the distribution of the remaining shares of the new company to the parent company's shareholders. Depending on market conditions and other factors such as compliance with debt and credit agreement restrictions, there may be a period of more than 90 days before the Parent distributes the remaining shares to its shareholders. During this period the parent will continue to have responsibility for the new company. In such a case, it would be in the interests of the Parent's shareholders, and quite likely within the expectations of the holders of the IPO shares, for the Parent to have representatives on the audit committee, who usually be would be defined as affiliates of the Parent. We would expect that the reliance on the exemption would be an important fact disclosed in the IPO registration statement.
Furthermore, even where there is no spin-off from a parent company, 90 days may be too short a period for the newly public company to put in place its permanent independent audit committee structure.
In addition, we recommend that more than one director be exempt during the one-year period, provided that a majority of the audit committee is independent. Under those circumstances, we can think of no valid reason to limit the exemption to just one director. For purposes of determining the majority of independent directors, we would consider together directors under this exemption plus directors qualifying under any other exemption that is also conditioned on a majority of the audit committee members being independent without relying on that exemption.
E. Exemptions To Accommodate The Home Country Requirements And Practices Of Foreign Private Issuers
The Commission correctly recognizes that the proposed requirements may conflict with legal requirements, corporate standards and the methods for providing auditor oversight in the home jurisdictions of some foreign issuers. In light of this, we support the Commission's proposals to provide certain exemptions for foreign private issuers. In addition, we recommend that the Commission make certain modifications to the proposed exemption for more-than-50% shareholders in order to permit the continued benefits of shareholder oversight, and that the Commission entertain requests for exemptions in the future as additional impacts of existing and future requirements become apparent in various jurisdictions.
The proposed Rule would allow one representative of a more-than-50% shareholder of a foreign private issuer to be on the audit committee. However, the shareholder representative would only be permitted as an observer without voting rights, and could not be chair of the audit committee. While we understand why the Commission may not want a shareholder representative to be chair of the audit committee, we believe that shareholder representatives should have voting rights, that the exemption should not be limited to one director as long as shareholder representative do not constitute a majority of the audit committee, and less-than-50% shareholders should also enjoy the same exemption.
Because share ownership of 10% or less in a company does not disqualify a person from being independent for audit committee purposes under the proposed safe harbor provision, the discussion in this Section covers only share ownership of more than 10%. In Section B above we urge the Commission to increase the threshold under the proposed safe harbor from 10% to 20%. As we did in Section C above, we have retained the reference to the currently proposed 10% threshold level in our discussion in this Section, but we believe that the threshold should be increased to 20%, and that the analysis and conclusions in this Section apply equally with a 20% threshold.
A significant shareholder is often best qualified to address matters audit committee are responsible for overseeing because the shareholder may have a better financial comprehension of the company than persons outside the company itself. Such understanding will generally derive from the financial expertise and substantial resources that significant shareholders generally devote to their significant ownership interests. A significant minority shareholder is just as likely to possess these attributes as a majority shareholder. However, the effect of the proposed exemption together with the safe harbor provision for 10% or less shareholders is to exclude 10-to-49% shareholders from being represented on the audit committee.
We do not believe that the independence of the audit committee would be compromised by permitting representatives of 10-to-49% shareholders to be on the committee; in fact, such shareholder representatives should be valuable members of the committee. Accordingly, we urge the Commission to provide in the final Rule that the exemption would apply to more than 10% ownership of the voting equity, rather than the proposed more-than-50% limitation. The 10% threshold is used based on the current safe harbor proposal that ownership of less than 10% of a class of equity does not make the holder a control person and affiliate. To alleviate any concerns about independence of the committee, we would include a requirement that a majority of the audit committee members be independent without the exemption for shareholder representatives. (Representatives of 10% or less shareholders would be deemed independent for this purpose in light of the proposed safe harbor provision.) With this majority independence requirement, we also would not limit the exemption to only one member of the audit committee.
Finally, the proposed limitation to observer status without voting rights appears to make the exemption illusory. Although there may be some circumstances, such as discussion of accounting and control issues with the auditors without management being present or consideration of specific, sensitive issues, where the audit committee would chose to exclude non-committee-member directors, we believe that interested directors generally would be able to attend audit committee meetings as non-voting observers.
We are not aware of any requirement or policy reason to generally exclude non-member directors from attending or "observing" audit committee meetings. In fact, we would think that audit committee members and non-member directors would welcome attendance in some cases such as discussion of pre-announcements of earnings results. In all events, members of the board of directors retain certain obligations and potential liabilities with respect to financial statements and financial disclosures even if they are not members of the audit committee. For example, the Commission recognized this in the final rules adopting requirements for disclosures regarding financial experts on the audit committee. Those new rules specifically provide that the designation of a financial expert on the audit committee does not affect "the duties, obligations or liability of any other member of the audit committee or board of directors."2
For the foregoing reasons, we urge the Commission to eliminate the restriction to non-voting observer status in the exemption. In addition, we ask that the Commission in the release adopting the final rules clarify that no negative implication that non-member directors generally are precluded from attending audit committee meetings was intended by the proposed limitation.
In sum, we urge the Commission to adopt an exemption permitting representatives of shareholders to be members of the audit committee of foreign private issuers if they are otherwise independent with respect to the issuer as long as shareholder representatives relying on the exemption do not constitute a majority of the audit committee.
For purposes of determining the majority of independent directors, we would consider together directors under this exemption plus directors qualifying under any other exemption that is also conditioned on a majority of the audit committee members being independent without relying on that exemption.
We do not agree with the Commission's proposal that it not entertain exemptions or waivers for particular relationships on a case-by-case basis or through its no-action letter process. In the Release, the Commission has specifically requested comments on foreign jurisdictions whose corporate governance arrangements conflict with the proposed rules. At this point, it is impossible to ascertain all of the foreign jurisdictions whose corporate governance standards are adequate to provide auditor oversight but conflict with the proposed rules. Moreover, the legal requirements in foreign jurisdictions may change in the future to accommodate changing economic or other environments.
Consequently, there is a danger that issuers from certain foreign jurisdictions whose corporate governance standards are adequate but conflict with the proposed rules may, currently or in the future, be barred from accessing the U.S. markets if such requirements are not identified during the comment period. Therefore, in order to provide the flexibility to address these issues in the future, we propose that the Commission entertain requests for exemptions or waivers on a case-by-case basis.
F. The Final Rules Should Provide A Longer Transition Period For Listed Companies Before Compliance Is Required
We have no problem with the implementation schedule included in the proposed Rule insofar as it applies to actions required of SROs. Our concern is that the proposed implementation schedule focuses almost exclusively on the time needed by the SROs, without providing adequate time for listed companies to come into compliance.
As proposed, the SROs would have 60 days after publication of the Commission's final rules in the Federal Register to provide their proposed rules to the Commission. This would give the SROs until approximately the end of June 2003 to submit proposed rules based on the Sarbanes-Oxley requirement that the Commission's Rule be adopted by April 26, 2003. The SROs must have their rules approved by the Commission by 270 days after publication of the Commission's Rule, which would be approximately the end of January 2004. We believe that this would provide adequate time for the SRO rulemaking process.
The problem is the proposed requirement that the SRO rules be operative (which we read to mean that companies would have to be in compliance to become listed or remain listed) by the first anniversary of publication of the final Rule in the Federal Register. This would be approximately May 1, 2004. Based on the implementation dates for the interim steps, the final SRO rules could be approved as late as the end of January 2004, leaving companies only about three months to come into compliance. We recognize that the broad outlines of the expected SRO rules should be known before approval of the final rules, and that many companies will attempt to come into compliance with the expected SRO rules before final approval. However, the implementation period for establishing the deadline for compliance with the severe sanction of delisting should be based on when the actual, final SRO rules are approved and known, which could be as late as the end of January 2004, allowing as little as three months for implementation.
More importantly, substantial lead time is required for a company to schedule any action at a shareholder meeting that may be needed to comply with the rules. We are assuming action at a regularly scheduled annual meeting in order to avoid the large expense and burden of a special meeting of shareholders. Many large companies hold their annual meetings of shareholders in the fifth or sixth month after the end of their fiscal year. Thus, under the proposed implementation schedule it could be physically impossible for companies with calendar year fiscal years to take shareholder action after approval of the final SRO rules and prior to the compliance deadline. It is worse for March 31, June 30 and September 30 fiscal year-end companies.
We believe that companies need a one-year period at a minimum after the final SRO rules are approved and before the date of their next annual meeting of shareholders to come into compliance with the rules. Companies with very large shareholder bodies typically send out proxy statements about two months before the meeting date. We estimate that up to three months should be added to that to allow for drafting the proxy statement, review by counsel, the board of directors, the audit committee and others, arranging for printing and distribution, ordering paper, and making other arrangements. This assumes that all arrangements or actions that may be required to implement the new rules (such as the search and selection process for a new candidate for director and obtaining the candidate's consent) have been finalized, which would allow as little as seven months for completing these preparations even under our proposal for a one-year implementation period. Of course, depending on when in the calendar year a company's fiscal year ends, and when the final rules are adopted, some companies will have more than one year. However, it is necessary to insure at least one year lead time for all companies.
Because the implementation time available for different companies will vary depending on their fiscal year-ends and when the final rules are approved for the applicable SROs, establishing a fixed date for all companies is not the most effective means to provide the compliance deadline. Instead, we recommend that the final rules require each company to be in compliance by its first annual shareholder meeting or other shareholder meeting at which directors are elected after the first anniversary of the approval by the Commission of the applicable SRO's rules, plus 30 days. That will automatically account for differences in fiscal year-ends and variations in when final SRO rules are approved. Also, while we believe that most companies hold their board organization meeting on the day of the annual meeting of shareholders, we propose allowing an extra 30 days to provide companies some flexibility in organizing the board committee structure following the annual meeting.
G. Comments On Other Issues Raised In The Release
The Release requests comments on a number of other issues. The following are the Committee's comments on some of the other important issues identified in the Release.
The proposed Rule makes clear that a member of an audit committee may not receive either indirect or direct compensation from the issuer. However, the Rule does not address pension or deferred compensation plans for former officers or employees, and the Release requests comments on whether clarification is necessary. The final Rule should eliminate this uncertainty by expressly excluding compensation received as a former officer or employee under pension, retirement, deferred compensation or similar plans from "compensatory fees" that would render a director non-independent. We do not believe that the existence of payments under such pension and other plans would adversely affect the ability of directors to be independent of management.
In addition, the proposed Rule provides that payment of compensation would be deemed to have occurred if the issuer makes, for example, payments to a law firm, accounting firm, consulting firm or investment banking firm of which the audit committee member is a partner. We propose adding language to the rule making clear that fees for services of $60,000 or less per year to a firm of which the director is a partner, member or principal would not disqualify the director from being deemed independent for audit committee purposes. A $60,000 threshold is consistent with the amount that would need to be reported in the proxy statement for transactions with management. We do not believe the receipt of fees for services in such de minimus amounts would adversely affect the ability of the director to be independent from management. The exception would avoid disqualifying an otherwise capable director by reason of occasional, minor consulting services or advice that may be provided by his or her firm.
In most cases the independence of audit committee members that would be required under the Rule will be based on objective criteria without the need for any judgment in making a determination. In those cases where the exercise of judgment is necessary, the board of directors would be the appropriate body to make the determination. The board has ultimate responsibility for the composition and functions of the various board committees including the audit committee. In addition, the board would be in the best position to assess the significance of specific factors on the ability of individual directors to perform in an independent manner on the audit committee.
The Release requests comment on whether, in connection with audit committee responsibility relating to the independent auditor, the committee also should have responsibility for the internal auditor. Specifically, the Release asks whether the audit committee should be responsible for the appointment, compensation, and retention and oversight of the internal auditor. The internal audit function is still a management function. For example, the independent auditor is prohibited from providing internal audit outsourcing services for an audit client under Regulation S-X rules implementing Section 10A of the Exchange Act as amended by Sarbanes-Oxley.
If the Commission believes there is merit in transferring responsibility from management to the independent audit committee, the Commission should undertake a study of the internal audit function. The study should address whether there is any serious problem in how the internal audit function operates currently with management responsibility that would call for placing direct responsibility with the audit committee.
The proposed Rule excludes from the definition of independence a director, other than in his or her capacity as a member of the audit committee, the board or another board committee, who is an affiliated person of the issuer or any subsidiary or who accepts compensatory fees from the issuer. The Commission proposes the traditional control definition of affiliate, with a safe harbor for parties that do not beneficially own more than 10% of any class of equity and are not executive officers or directors of the issuer. This is basically the same safe harbor that the Commission previously proposed but never adopted for Rule 144 affiliate purposes. Because of the introductory language of the definition -- "other than in his or her capacity as a member of the audit committee, the board of directors, or any other board committee" -- presumably a director can still rely on the safe harbor even though he or she is a director of the issuer. It would be helpful if the Commission would expressly confirm this in the adopting release or in the final Rule.
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We hope the Commission finds these comments helpful. We would be happy to meet with the Staff to discuss these comments further.
Michael J. Holliday, Chair
The Honorable William H. Donaldson, Chairman