March 14th , 2003
Mr. Jonathan G. Katz
Comments on the implementation of
Dear Mr. Katz:
We are writing to comment on the proposed Rule 10A-3 under the Securities Exchange Act of 1934, implementing Section 301 of the Sarbanes-Oxley Act, in particular with respect to the application of the audit committee independence rules to the Telefónica group. We believe that while our home country corporate governance regime is basically consistent with the principles underlying the Sarbanes-Oxley Act, accommodations may be necessary in order to avoid conflicts between Spanish law and practice and the proposed rule.
Telefónica, S.A. is listed in nine countries and eleven of the group's subsidiaries are SEC-reporting companies. In addition to their US listings, these subsidiaries are listed in five different home countries and we have eight other subsidiaries listed outside the US. As a result, we are deeply concerned about the overlap of laws and regulations concerning corporate governance, which in some cases are inconsistent, and which will demand from us a costly and inefficient effort to comply with different regulations aiming at the same objectives.
We encourage the Commission to take a flexible approach, eliminating legal conflicts and relying where possible on existing home country rules to ensure that foreign private issuers with securities listed in the United States will meet the high standards of transparency and ethical conduct that the Sarbanes-Oxley Act seeks to reinforce.
More specifically, the most important areas that present cause for concern are:
A. Representatives of Controlling Shareholders on the Audit Committee
As the Commission noted in the proposing release, controlling shareholders are indeed common outside the US, as the number of our listed subsidiaries illustrates. While we share the Commission's view that the audit committee should be an independent check on a listed company's financial reporting system and management, we believe that full participation of controlling shareholders in the audit committees is consistent with this aim. In our view, the Commission's approach of limiting the role of controlling shareholders on the audit committee goes beyond what is necessary to safeguard the interests of public securityholders, goes beyond the scope of Section 301 of the Sarbanes-Oxley Act, and ultimately discriminates against controlling shareholders.
Under Spanish corporate law, there is a relation between the capital structure of a limited liability company and its board composition. In this respect, the Spanish Law on Public Companies (the "LSA") provides a specific mechanism in order to ensure proportionate representation of shareholders at the board of directors (article 137 LSA). Thus, a shareholder owning 50% of the share capital of a company has the right to appoint 50% of the directors on a board.
Moreover, Spain has recently enacted a financial law that requires Spanish listed companies to create audit committees with a majority of non-executive directors. Similar to the Commission's proposal, this new law provides an independent check on management. Unlike the proposed Exchange Act rule, however, the new Spanish law permits representatives of shareholders, as non-executive directors, to attend and vote at meetings of the audit committee and to constitute the majority of the committee.
We are pleased to note the Commission's recognition of the legitimate interests of controlling shareholders to participate in the audit committee, but believe that the proposed exception is insufficient in several respects, and if enacted as proposed would discriminate against significant shareholders. Our principal concerns are:
In sum, while we believe that the audit committee should contain at least one member representing public shareholders, we believe that significant shareholders should have the right to represent their shareholdings on the committee as well. As owners, they have a legitimate interest in monitoring how the subsidiary is run and in the quality of the subsidiary's financial statements and audit. For a group with the international scope of Telefónica, it is essential that we participate fully in the financial reporting processes of our subsidiaries, whether listed or not, in order to monitor their good working order and ensure that their financial reporting is satisfactory. In this regard, we believe that a controlling shareholder should have the power to approve or disapprove financial statements that it will be required to consolidate and to control other decisions of the committee.
For similar reasons, we are concerned that the proposed limitation of the participation of controlling shareholders could negatively impact the ability of chief executive officers and chief financial officers of parent companies to make the certifications required by Section 302 and Section 906 of the Sarbanes-Oxley Act, particularly if the parent company were to disagree with the subsidiary regarding a material accounting issue.
In the case of foreign private issuers, the Commission and the New York Stock Exchange have frequently deferred to home country laws and practices, particularly with respect to corporate governance, and we would encourage the Commission to continue to embrace this approach. We believe that the successful globalization of securities markets is due in part to the practice of many regulators to apply their disclosure requirements to foreign issuers, while permitting the regulator of the issuer's home country to regulate corporate governance. We are concerned that the implementation of corporate governance rules by secondary markets, such as those in the proposed Rule 10A-3, may provide a major disincentive to issuers to list outside of their home countries, and in particular in the United States. We therefore urge the Commission to use the exemption authority expressly granted to them under Section 10A(m)(3)(C) of the Exchange Act to exempt foreign private issuers from the independence criteria of Section 10A(m)(3)(B), and permit home country rules to define independence. In the alternative, we would encourage the commission to modify the foreign issuer controlling shareholder exception as discussed above.
(b) Exemption for Debt Issuers
We agree with the Commission that it is appropriate to provide an exemption from the proposed audit committee requirements for issuers of listed debt securities that are subsidiaries of a parent company whose equity securities are listed in the US. We believe that this exemption should also apply to subsidiaries that list equity securities. We believe that the principle underlying this exemption, namely that the existence of a properly constituted audit committee at the parent level offers a high level of protection to stakeholders in its subsidiary, has some bearing in the analysis of the protection that shareholders of subsidiaries should have. If assurance may be derived from the fact that the majority shareholder is listed in the US, one would conclude that that shareholder should be able to exert a considerable degree of influence on its subsidiary, including participation in its audit committee. Why would such protection, so desirable in the context of debt securities, be deemed pernicious or dangerous if the same subsidiary offers equity securities?
(c) Appointment of Auditors by the Audit Committee
The proposed requirement that the audit committee be directly responsible for the appointment, compensation, retention and oversight of the company's auditor is on its face inconsistent with Spanish law, although the proposed instruction attempts to mitigate this effect. Under Spanish law, auditors are appointed by the company's shareholders at their general meeting. Committees of the board of directors do not have any power under the company's articles of incorporation to make such appointments, nor do they have power to independently take any action. They are in effect limited to making recommendations to the Board of Directors, which may then take appropriate action. Nonetheless, under the new Spanish financial law discussed above, audit committees are required to submit to the Board of Directors proposals for the appointment of the external auditors of the company, which shall in turn be submitted to the general shareholders' meeting.
Although the Commission implies in its discussion of the proposed requirements that such practices would be sufficient to accomplish the requirements of Section 301 of the Sarbanes-Oxley Act, we believe that the wording of the proposed instruction ("the requirement . . . does not conflict with . . . an issuer's governing law . . . that requires shareholders to ultimately elect . . . the issuer's auditor.") could be improved to clearly indicate that this Spanish practice, and similar practices in other countries, satisfies the proposed rule. We would suggest wording the instruction or the rule to state affirmatively that, where home country law requires shareholders to elect, approve or ratify the selection of the issuer's auditor, an issuer will satisfy the requirements of 10A-3(b)(2)(i) when the auditor recommended by the audit committee is presented to shareholders for their approval.
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Please feel free to contact the undersigned at + 34 91 584 06 07, if you would like to discuss these comments further.