February 25, 2003
Via e-mail: email@example.com
Securities and Exchange Commission
Re: Standards Relating to Listed Company Audit Committees
Ladies and Gentlemen:
This letter is submitted on behalf of the Committee on Federal Regulation of Securities of the American Bar Association's Section of Business Law (the "Committee")* in response to the Commission's request for comments on the above-identified Release issued January 17, 2003 regarding Standards Relating to Listed Company Audit Committees (the "Release").
The comments expressed in this letter represent the views of the Committee only and have not been approved by the American Bar Association's House of Delegates or Board of Governors and therefore do not represent the official position of the ABA Section of Business Law, nor does it necessarily reflect the views of all members of the Committee.
As directed by Section 301 of the Sarbanes-Oxley Act of 2002 (the "Act"), the Commission has proposed a rule to require that the U.S. securities exchanges and the NASDAQ Stock Market (the "SROs") prohibit the listing of any security of a company that is not in compliance with specified requirements concerning its audit committee. These requirements relate to: (i) the independence of audit committee members; (ii) the audit committee's responsibility to select and oversee the listed issuer's independent accountant; (iii) procedures for handling complaints regarding the listed issuer's accounting practices; (iv) the authority of the audit committee to engage advisors; and (v) the funding of audit committee activities. The proposals also would require listed issuers, and in some respects non-listed but registered issuers, to make additional or revised disclosures regarding their audit committees.
The Act, and Section 301 in particular, are important developments in our nation's system of governance and disclosure for publicly-owned companies. In Section 301, the Congress undertook an unprecedented federal involvement in the regulation of corporate governance, intended to help ensure the accuracy and quality of the financial reports of listed companies by promoting the independence and effectiveness of audit committees in performing their key role in the financial reporting process. The Congress determined, however, that this corporate governance initiative should be effectuated by a listing standard, with delisting as the sanction for noncompliance. This mechanism has the advantage of making the experience of the SROs available in applying and interpreting governance listing standards. Consistent with this approach, the Commission has wisely chosen to permit the SROs, for the most part, to implement the statutory requirements through specific criteria established in the listing standards they adopt and through their interpretation and application of those listing standards.
The adoption by SROs of listing standards regarding audit committees in accordance with the rule the Commission will promulgate under Section 301 should also be viewed, as the Commission points out in the Release, in the context of the recent initiatives which the New York Stock Exchange ("NYSE") and NASDAQ Stock Market ("NASDAQ") have undertaken to establish other listing standards regarding corporate governance matters. These proposals are currently pending before the Commission. These initiatives will also be important in accomplishing certain of the goals underlying the Act. It is desirable that the listing standard mandated by Section 301 and the other corporate governance listing standards established by the SROs be compatible. The changes in board and board committee composition and practices should be implemented in a consistent and efficient manner. In the implementation process, continuity in the performance of board functions should be preserved, with structural changes achieved to enhance the successful functioning of the board. Accordingly, the timing for companies to come into compliance with the listing standards mandated by Section 301 should be carefully considered with regard to both the feasibility of successful implementation of those listing standards and their integration with the other corporate governance listing standards to be adopted by the SROs affecting board composition and committee structure.
We also note that the primary sanction for violation of a listing standard is delisting. Delisting is a remedy with significant adverse consequences both to the issuer and its shareholders. Realistically, the failure to conform to a corporate governance listing standard in one primary market will leave no alternative comparable trading opportunity available for the company. Furthermore, if a company is delisted it will no longer be subject to the requirement that it adhere to the audit committee and other governance practices which form part of an SRO's listing standards. Accordingly, it is important for both the Commission and the SROs to ensure that (1) listed companies are afforded a full measure of due process to determine if there has been substantive noncompliance, (2) feasible opportunities to remedy noncompliance are provided and (3) alternative enforcement measures are available in appropriate situations before resort to the drastic measure of delisting.
We generally support both the substance of the audit committee requirements the Commission has proposed and the Commission's approach to implementation of the requirements. We also commend the Commission for the effort reflected in the Release of identifying the various considerations that impact the terms of its proposals. The proposed audit committee requirements fairly reflect the important role which audit committees play in the financial reporting and corporate governance processes. As the Congress intended, the requirements the Commission has proposed are broad and leave it to the SROs to establish specific criteria for applying these requirements and to interpret and enforce them using their experience and knowledge of the variety of circumstances affecting their listed issuers. Our primary concern with the proposals relate to certain aspects of how the proposed requirements are to be implemented. Our general comments on the Commission's proposal are summarized below, after which we present our comments on specific proposed provisions and respond to questions raised by the Commission.
We provide below comments on the following specific matters raised by the Release:
I. The Substance of the Minimum Standards to be Applied to Audit Committees
A. Audit Committee Member Independence
Section 10A(m)(3) of the Exchange Act prohibits the listing of an issuer's securities if, among other things, any member of the issuer's audit committee lacks independence because he or she (a) "accept[s] any consulting, advisory or other compensatory fee" from the issuer or (b) is "an affiliated person of the issuer or any subsidiary of the issuer". The Commission proposes criteria for applying the statutory "no compensatory fee" and "non-affiliation" standards of independence based on the premise, with which we concur, that, as stated by the Commission in the Release, "[a]n audit committee comprised of independent directors is better situated to assess objectively the quality of the issuer's financial disclosure and the adequacy of internal controls than a committee that is affiliated with management."1 We are concerned, however, that in certain respects, as discussed below, the Commission's proposed independence criteria are too rigid and, if adopted as proposed, would unnecessarily preclude well-qualified, objectively independent directors from serving on the audit committee. This outcome would be contrary to the best interests of issuers and investors alike.
The proposal disqualifies from audit committee membership a director who accepts indirect fees, as well as direct fees, from the issuer or a subsidiary of the issuer. The proposed rule defines "indirect acceptance" of "any consulting, advisory or other compensatory fee" to include "acceptance of such a fee" by (i) the director's "spouse, a minor child or stepchild or a child or stepchild sharing a home" with the director or (ii) "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."2
We support the Commission's goal of preventing evasion of the prohibition on compensatory fees to audit committee members by also proscribing fees paid not to the director but to a close relative or an entity with which the director is closely associated ("indirect fees"). We are concerned, however, that treating incidental or immaterial compensatory payments between an issuer and a relative of a director as disqualifying a director from audit committee service would risk narrowing too greatly the pool of qualified candidates and risk disqualification of audit committee members as a result of a relationship coming into existence which has no realistic prospect of affecting the director's independence. This may be particularly so in the case of large companies which may have thousands of employees and may in the ordinary course of business contract with hundreds of suppliers of services at dozens of locations. We suggest that, for example, payment by a listed company in the ordinary course of its business to a relative of a director (or an entity that employs the relative) who is a marketing expert for advice on marketing one of the company's products should not automatically disqualify the director from audit committee service without any consideration of the amount of the payment or the circumstances.
We urge that the rule permit the SROs to develop criteria or procedures that would avoid automatic disqualification of a director from audit committee service by reason of incidental or immaterial compensatory payments to a relative of a director. (No such exception would, however, be available with respect to payments directly made to a director.) Examples might include an exception for ordinary course compensation for non-management personnel of less than an appropriate threshold amount or a procedure whereby the other independent directors of an issuer could determine that, in the circumstances, a compensatory payment would not be material to the director's independence. We note that similar concepts exist in the recent amendments proposed by the NYSE to their corporate governance listing standards.3
The Commission notes in its Release that it does not intend for the proposed prohibition on compensatory fee payments to audit committee members to "preclude independence on the basis of ordinary course commercial business relationships between an issuer and an entity with which a director had a relationship."4 We concur with this view. However, we suggest that the Commission include in the rule provisions which embody this principle. There are a wide variety of circumstances in which an issuer may make payments to an entity with which a director is associated and these relationships could otherwise be characterized as giving rise to indirect payments that would disqualify a director from audit committee service, even though the relationship in fact would have no propensity to interfere with a director's independent judgment. We believe including such provisions in the rule will provide important guidance for the SROs in developing and applying listing standards regarding audit committee member independence, and for issuers in coming into compliance with these listing standards, so as to achieve the goals of the rule without unduly restricting the candidates for audit committee membership. For example, there may be many instances where, as part of an ordinary course, commercial business relationship between an issuer and a supplier of goods or services to the issuer, some consulting, advisory or similar services are provided to the issuer incidental to supplying goods or other services, such as assistance in installing or maintaining software or equipment that has been supplied to the issuer or training its employees in the use of software or equipment.
We believe that a director who would otherwise be considered independent should not be disqualified from audit committee membership because he or she is associated with an entity which supplies consulting, advisory or similar services where such services, in the ordinary course of commercial business relationships, are supplied incidental to the supply of goods or other kinds of services or are otherwise part of an ordinary course commercial relationship. We note that the Act identifies as disqualifying payments not all payments made by a listed company or its subsidiaries from which a director may in some way benefit but only those that constitute "consulting, advisory, or other compensatory fees [emphasis added]," implying that it is payments for personal services that were considered to threaten a director's independence for audit committee purposes, not ordinary course commercial arrangements of the issuer that may involve consulting, advisory or similar fees in which the director has no direct participation. This clarification could be included in the statement of the independence requirement in section (b)(1)(ii) and (iii) of the proposed rule or in the definition of "indirect acceptance" of any consulting, advisory or other compensatory fee in section (e)(6) of the proposed rule.
For purposes of determining whether an individual is an "affiliated person" of a listed company, as referred to in Section 301, the Commission proposes to apply a "control" test, as used in many other areas of the securities laws (such as Exchange Act Rule 12b-2 and Securities Act Rule 144). This approach requires a weighing of facts and circumstances and can require a sophisticated legal analysis to determine whether one person is in "control" of another, an analysis that ultimately, given existing precedent, may produce an uncertain conclusion. Embodying this degree of uncertainty in the independence criteria for audit committee membership, without further clarification, would make it unduly difficult for boards of directors to determine who qualifies for audit committee membership and risks unduly restricting the pool of candidates for membership. Recognizing these considerations, the Commission sensibly includes in its proposed rule a "safe harbor" to apply in determining whether an individual is an affiliated person of the issuer. With reference to the definition of insider used for purposes of Section 16 of the Exchange Act, the Commission's proposed safe harbor provides that a "person" will be deemed not to be "in control" of the issuer if three conditions are met: (a) the person is not the beneficial owner of more than 10% of any class of the issuer's equity securities, (b) the person is not an executive officer of the issuer, and (c) the person is not a director of the issuer.
We consider it important to provide issuers with guidance concerning the potential control relationships that do not pose risks to the exercise by an audit committee member of the independent oversight and business judgment required by the role. We support the Commission's proposal to include a bright-line, safe harbor for this purpose. We are concerned, however, that certain aspects of the proposed safe harbor will not accomplish this purpose and will in practice needlessly disqualify directors from audit committee membership.
First, we suggest that beneficial ownership of securities that provide voting power in the election of directors would be a more appropriate standard in order to determine independence. It is the ability to use voting power attendant to security ownership to influence the management of a company's business and affairs that presents a risk to independent judgment; security ownership by itself does not present this risk. Accordingly, voting power is a more effective and realistic standard than percentage ownership of any single class of equity security. In any event, we recommend that the language of the safe harbor be clarified so as not to preclude reliance on the safe harbor by a director because of his beneficial ownership of nonvoting equity securities or equity securities that do not provide voting power in the election of directors above a specified threshold, whether his beneficial ownership arises from one or several classes of securities.
Second, we are concerned that the 10% beneficial ownership threshold is inappropriate for use in the safe harbor. Ten percent is not a level of beneficial ownership that generally confers a controlling influence over the management of a company's business and affairs. The use in Section 16 of the Exchange Act of a 10% beneficial ownership threshold is based on the potential for access to and abuse of inside information, a consideration not applicable in the present context. Applying as part of the safe harbor a 10% threshold could exclude many well-qualified directors from audit committee service who in fact are wholly independent of the management of the company's affairs. For example, 10% beneficial ownership may result from otherwise unrelated shareholders having formed a "Section 13(d) group" with regard to sales of securities under a registration rights agreement.5
Accordingly, we suggest that the safe harbor also be available where a two-prong test relating to beneficial ownership of a listed company's shares is satisfied, similar to the two-prong test recommended by the Commission's Advisory Committee on Capital Formation and Regulatory Processes (the "Advisory Committee"). Specifically, the safe harbor would exclude from treatment as an "affiliated person" (i) a person who beneficially owns no more than 10% of the voting power in the election of the listed company's directors and (ii) a person who owns more than 10% but less than 20% of the voting power in the election of the listed company's directors and who does not have a right to designate any of the company's directors. As in the case of the Advisory Committee recommendation, a shareholder would not be deemed to have the right to designate a director merely because it possesses voting power (up to 20%) in the election of directors, which it may exercise as a holder of any class of shares on a pro rata basis with all other holders of shares having voting power in the election of directors and apart from any contractual relationship with the issuer, its management or other shareholders. We note that the up to 20% threshold is consistent with the accounting standard used to determine whether one entity has "significant influence" over another entity for purposes of assessing whether the entities should be subject to the equity method of accounting.6 In addition, the suggested threshold is consistent with that proposed by NASDAQ for use in the "affiliated person" test in its proposed corporate governance listing standards.7
Third, the Commission should clarify the language of the safe harbor so as to confirm that directors of the issuer do not by virtue of the safe harbor's reference to directors fall within the "affiliated person" definition -- otherwise, each potential audit committee member, as a director of the issuer, a fortiori would be deemed an "affiliated person" of the issuer and disqualified from audit committee service.
Finally, paragraph (ii) of section (e)(1) of the proposed rule deals with the status of a director who is associated with a company that is considered a "controlling" shareholder by specifying that: "A director, executive officer, partner, member, principal or designee of an affiliate will be deemed to be an affiliate." We believe the Commission should make clear that outside directors of the controlling shareholder who would otherwise qualify as independent are excluded from this provision; such exclusion would be consistent with the exemption provided by Proposed Rule 10A-3(b)(1)(iv)(B). We also are concerned that this provision is overbroad, particularly as applied in the venture capital and investment management context. It should be clarified that passive ownership positions that do not involve management or control (such as limited partner status) should not be presumed to be disqualifying.
We trust that in the adopting release the Commission will confirm that if a director is not deemed independent for audit committee purposes because of the inability to comply with the safe harbor, there is no presumption that the director cannot otherwise be found to be independent for such purposes.
The Commission inquires whether the prohibition on compensatory payments should include compensation under a retirement or similar plan in which a former officer or employee of the issuer participates. We understand the reference to "a retirement" plan to include but be broader than a funded plan governed by the Employee Retirement Income Security Act of 1974, including unfunded supplemental retirement benefit plans or arrangements. The fact that an individual receives retirement benefits from a listed company in connection with his or her former employment should have no bearing on whether or not the individual is independent for purposes of serving on the audit committee, as long as the individual is entitled to receive the payments and the amount of the payments are not discretionary with the listed company. We believe such fixed payments are unlikely to impair or even bear upon an individual's objectivity. Therefore, we suggest the Commission clarify that retirement benefits paid by the issuer or a subsidiary of the issuer to an individual of this nature would not disqualify that individual from serving on the audit committee.
The Commission also solicits comment on whether the board of directors should be required to determine that an audit committee member is independent and, if so, whether the board should be required to disclose this determination. We believe it should be left to the SROs whether the board should be required to determine if an audit committee member is independent. We note that while the NYSE proposal would require the board affirmatively to determine that the director has no material relationship with the issuer that could impair his or her independence,8 the NASDAQ proposal includes no such requirement. The SROs are in the best position to assess whether their respective listed companies would be best served by having the board, or some subset thereof, make the determination or by having the determination rest solely on objective criteria set forth in the applicable listing standards. In addition, we note that the Commission's existing disclosure requirement in Item 7(d)(3)(iv)(A) of Schedule 14A provides that an issuer must disclose whether the members of its audit committee are independent. We believe this existing requirement provides adequate disclosure regarding audit committee member independence and no further disclosure is necessary. As a practical matter, the board will only appoint members of an audit committee it deems to be independent.
The Commission also inquires whether the proposed 90-day exemption permitting one member of the audit committee for new public companies not to satisfy all the independence criteria of the rule is appropriate. We strongly believe that the proposed 90-day exemption for new public companies is inadequate. The enhanced independence requirements, coupled with the additional burdens placed on audit committees under the Act and the Commission's implementing rule, will make it challenging for new public companies to identify qualified audit committee members. Moreover, issuers and investors alike will benefit from continuity on the audit committee when an issuer goes public. Therefore, we suggest that the final rule should include an exemption from the independence requirement for one member of the audit committee, regardless of the size of the committee, provided that (1) such member is not a member of the company's management and (2) at least one member does meet the independence criteria for the period from the date on which the issuer's initial registration statement becomes effective until the date of the annual meeting of the issuer following the first anniversary of the date on which the issuer's initial registration becomes effective (but in no event more than 180 days after the first anniversary of the date on which the issuer's initial registration becomes effective). To the extent that the company is a Covered Company (as defined below), a longer transition period for a Covered Company will apply.
The Commission also seeks comment on whether the independence criteria should include a "look-back" period. We agree with the Commission that the independence requirements should relate to current relationships and that no "look-back" period is necessary.
Finally, the Commission seeks input on whether issuers should be allowed to request exemptive relief on a case-by-case basis; whether there should be an exception to the independence requirements in exceptional and limited circumstances; whether there should be additional criteria for independence apart from the two proposed criteria; and whether additional relationships should be exempted from the independence requirements. In response to all these inquiries, we recommend that such determinations should be addressed by the SROs, which are best suited to deal with these issues. As indicated above, the SROs should have sufficient flexibility under their standards to deal with exceptional circumstances.
B. Audit Committee Responsibility Relating to Auditor Oversight
The proposal would require that audit committees be directly responsible for the appointment, compensation, retention and oversight 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 related work or performing other audit, review or attest services for the listed issuer, and each such registered public accounting firm must report directly to the audit committee."9 We agree with the Commission's comment in the Release that having the audit committee hire, evaluate and, if necessary, terminate the outside auditor is an important step in helping to ensure that the auditor is independent.10 However, we encourage the Commission to clarify that these responsibilities are not inconsistent with, and are not intended to undermine, the audit committee's responsibility to report regularly to the full board of directors regarding these matters so as not to interfere with the oversight function of the full board. We note that Section 10A(m)(2) of the Exchange Act highlights the relationship between the audit committee and the full board in this instance when it says that the audit committee should perform the specified functions "in its capacity as a committee of the board of directors, . . . ."
We note that the proposal incorporates some additional language beyond that set forth in the relevant text of the Act. Specifically, the proposal includes the phrase "for the purpose of . . . performing other audit, review or attest services for the listed issuer," in addition to the text of the Act, which states "for the purpose of preparing or issuing an audit report." We raise this point only because this additional language results in some asymmetry between the Act and the proposal, such that certain foreign accounting firms could be left with the misimpression that they have to register with the Public Company Accounting Oversight Board (the "Board"). Section 106(a)(2) of the Act provides that the Board by rule may determine that a foreign public accounting firm that does not prepare or issue an audit report but that nonetheless plays "a substantial role in the preparation and furnishing" of such reports may be required to register with the Board. But the Board's authority to require such foreign accounting firms to register has not yet been exercised. Meanwhile, the proposal could be construed to require that a foreign accounting firm, other than the primary auditor, "performing other audit, review or attest services for" a foreign subsidiary of a listed issuer must register with the Board because the proposal refers to "any registered public accounting firm." Therefore, the Commission should clarify that the audit committee's responsibility for the appointment, compensation, retention and oversight of the auditor extends only to those auditors that are in fact required to register with the Board, and that Proposed Rule 10A-3(b)(2) itself imposes no independent registration requirement for foreign public accounting firms.
We also have some concerns regarding the Commission's suggestion that it may expand the narrow, but important, mandate set forth in Section 10A(m)(2) of the Exchange Act to encompass audit committee authority for the appointment, compensation, retention and oversight of an issuer's internal auditor. The NYSE's proposed corporate governance listing standards, the audit committee charters of many companies and a significant body of recent corporate governance literature all highlight the role that the audit committee should play in relation to the internal auditor and the internal audit function.11 But, unlike the established regulatory requirements that have existed with respect to the independent auditor, there is no generally accepted corporate practice for internal auditors and the internal audit function. Therefore, while we believe that audit committee oversight of the internal audit function should be encouraged as a good practice, the relationship between the audit committee and the internal auditor should be given time to evolve. Accordingly, we believe it would be premature for the Commission to mandate the scope of responsibilities of the audit committee over the internal auditor.
The Commission also solicits comment on whether proposed Instruction 1 to Proposed Rule 10A-3 adequately addresses concerns of issuers whose governing law or charter documents require shareholder selection of the auditor. Whether or not the shareholder selection of the auditor is mandated, we do not believe that the Congress intended that shareholders could not have an ultimate approval or ratification right which is a common practice with a long history. Accordingly, we suggest that the rule specifically make provision for shareholder approval or ratification, provided that if the auditor is not approved, the matter would be referred back to the audit committee and not the board of directors. It would not be in the interest of shareholders for this longstanding shareholder approval practice to be discontinued.
C. Procedures for Handling Complaints
The proposal implements Section 10A(m)(4) of the Exchange Act by providing that each audit committee would need to establish procedures for both (a) the receipt, retention and treatment of complaints received by the issuer regarding accounting, internal accounting controls or auditing matters and (b) the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters.12 The Commission notes in the Release that it has not mandated specific procedures that the audit committee must establish because it believes "companies should be provided with flexibility to develop and utilize procedures appropriate for their circumstances."13 We strongly support the Commission's decision not to adopt specific procedures. We also agree with its assessment that the most effective processes will be developed as companies tailor their procedures to their particular circumstances with the benefit of any guidance they receive from the SROs.
D. Authority to Engage Advisors
Consistent with the Act, the Commission's proposed rule provides that "each audit committee must have the authority to engage independent counsel and other advisers, as it determines necessary to carry out its duties."14 We support this aspect of the Commission's proposal and agree with the Commission's view that allowing the audit committee the discretion to engage outside advisers is of benefit to the issuer.15 The Commission inquires whether any additional specificity is needed for this requirement. We suggest the Commission further highlight that an issuer's audit committee would not be precluded access to or advice from the company's internal or outside counsel or other advisors and the audit committee would not be required to retain independent outside counsel or other advisors. Otherwise, we believe this aspect of the proposal is sufficiently clear.
Section 10A(m)(6) of the Exchange Act directs the Commission to require the SROs to adopt rules that would obligate issuers to provide appropriate funding for payment of compensation to (a) any registered public accounting firm engaged for the purpose of rendering or issuing an audit report and (b) any advisors employed by the audit committee. The proposed rule closely adheres to this directive.16 The Commission inquires whether additional specificity on this aspect of the proposal is needed. In this instance, we believe that it would be appropriate to supplement the funding requirements. Specifically, the final rule also should state that the issuer must provide appropriate funding, as determined by the audit committee, for ordinary administrative expenses necessary for the audit committee to carry out its duties.
The Commission also seeks comment on whether a specific agreement or arrangement should be required to satisfy the audit committee funding mandates. We believe this additional step would prove too mechanical and would provide no tangible benefit to investors, issuers or advisors because issuers will comply with the funding mandates in any event, or risk being delisted. For this reason, we believe that requiring a specific agreement or arrangement for the funding mandates is unnecessary. Instead, issuers should be afforded the flexibility to determine the manner in which they comply with the funding requirements.
Finally, the Commission solicits comment on whether there should be a limit on the amount of compensation that could be requested by the audit committee. As an initial matter, any such limit would be at odds with the plain language of Section 301 of the Act, which provides that "[e]ach issuer shall provide for appropriate funding, as determined by the audit committee . . . for payment of compensation . . . ." The text of the Act makes no mention of any limit on the amount of compensation that could be requested by the audit committee. The legislative history of the Act reinforces this point; the Senate Report notes that the Act requires that issuers "provide audit committees with authority and funding to engage independent counsel and other advisers as they determine necessary in order to carry out their duties."17 In addition, establishing a limit on the amount of compensation that could be requested by the audit committee addresses no rational policy concern because there likely would be instances where an audit committee would need to submit a compensation request that exceeded any established limit in order to protect the issuer's, and ultimately the investors', interests. Moreover, to the extent that the suggestion for a limit on compensation is driven by a concern that audit committees may submit exorbitant requests, it is worth noting that audit committees would be constrained in submitting such requests by both their own fiduciary duties to the issuer and the oversight that the board of directors as a whole has over the audit committee. The audit committee is a committee of the board and is still subject to oversight by the board, which is only constrained by the Act's duty to fund for the specified purposes of the audit committee.
II. Application and Implementation of the Proposed Standards
A. Compliance Deadline
Paragraph (i) of section (a)(5) of the proposed rule requires the SROs to require listed companies to comply fully with the audit committee listing standards mandated by the rule by the first anniversary of the publication of the rule; we assume this anniversary date will be in late April or early May 2004. Paragraph (iii) of section (a)(5) of the proposed rule requires, in effect, that the required audit committee listing standards of the SROs be in effect not later than late February or early March of 2004. There are several considerations to bear in mind in establishing an appropriate deadline for listed company compliance with the audit committee listing standards mandated by the proposed rule. We believe the proposed deadline for listed company compliance is impractical with respect to the proposed independence requirements for audit committee membership.
It is important to achievement of the Act's goal of improved corporate governance practices that the changes in board composition required by the audit committee standards the SROs are to adopt and certain of those that may be required by the other corporate governance listing standards the SROs are expected to adopt should occur on an organized basis and on a single occasion to the fullest extent practicable. To require a company to change its board composition to satisfy the audit committee requirements and then to make a second round of changes to conform to other governance standards will not facilitate good governance. Directors have important responsibilities beyond service on audit or other committees and their ability to contribute to the companies they serve is not based solely on their satisfaction of independence criteria. Directors as a group must coordinate their efforts in order to function as a resource for the company, exercising oversight of management and providing effective direction of corporate strategies and policies. Restructuring the composition of a board while preserving effective board functioning is a significant task, and to be done well the changes must be tailored to the circumstances of the particular company involved, which will vary significantly among the approximately 7,250 listed companies which will be subject to the rule's requirements.18 The interests of investors will not be served by requiring boards to undertake these organic changes on a repeated basis within a short period.
Many companies will need to recruit new directors, not only for service on audit committees but also to meet other board needs under the other new corporate governance listing standards expected to be adopted by the SROs. The objective is to ensure an appropriate balance of capabilities, experience and backgrounds for the proper functioning of both board and committees. Expecting several thousand director searches to be completed successfully in a period of a few months does not seem practical. Accordingly, an appropriate transition period should be allowed so that the end result across the universe of listed companies will be an audit committee, other committees and a full board of directors that can function effectively. The implementation challenge will be especially difficult for many smaller companies, which do not have the contacts, infrastructure and resources which larger companies may utilize in recruiting directors. Accordingly, in considering an appropriate implementation timeframe for compliance, separate consideration should be given to the circumstances of such companies.
We recognize that the Congress intends that audit committees be reconstituted as necessary to meet Section 301's independence standard as soon as may be practicable. The statutory mandate that the Commission adopt implementing rules under Section 301 by April 26, 2003 supports this premise. Nevertheless, a practical timeframe for implementing these standards can be made consistent with the SROs' other relevant corporate governance initiatives in a reasonable time period. We believe that, at least with respect to matters affecting board composition, the deliberations of the SROs regarding the corporate governance standards they should establish, which have already been discussed publicly for some time, should come to a conclusion in the near future, in the same timeframe as the audit committee requirements. This would make it possible for the board changes necessary to ensure audit committee independence and those necessary for other good governance purposes to be made on a one time basis within a reasonable time. Indeed, we expect that many companies will seek to make the changes as soon as they reasonably can, in advance of any mandated deadline. For companies to do this, however, they need to see the "whole picture" of the board composition requirements of the applicable listing standards to which they will be subject.
The proposed rule contemplates that listed companies would be required to comply with the required listing standards on the first anniversary of the rule's publication in the Federal Register. Assuming the rule is adopted by April 26 and published on May 1 of this year, this would require over 7,250 companies to effectuate the necessary board changes by May 1, 2004. Virtually all calendar year companies will have prepared their proxy materials by March 2004 for a shareholders' meeting in May or June and would usually have finalized the slate of directors to present to shareholders several weeks before, at the latest. Any director recruiting efforts would have been undertaken months earlier. Therefore, compliance could not be achieved by May 1, 2004. A special shareholders' meeting would be required (assuming the necessary recruiting and other efforts could be accomplished), which would be impractical and expensive. While it may be possible in some cases for a board of directors to achieve compliance with the audit committee independence requirements by filling vacancies, rather than by the election of new directors by shareholders, this is not a desirable means of achieving good corporate governance goals. These practical problems of compliance with a May 2004 deadline for audit committee independence will only be compounded by the need for listed companies to come into compliance with other corporate governance requirements.
We suggest that the timing problems that will arise in implementing the audit committee membership requirements mandated by Section 301 and other corporate governance listing standard requirements affecting board composition can be remedied by relating the compliance deadline for the audit committee membership requirements to the first anniversary of the adoption of the SRO rules required by Section 301. We believe that the required audit committee listing standards can be finalized by the SROs during the summer of this year and therefore issuers having a calendar year for financial reporting purposes would have the opportunity to take the necessary steps and present the required changes in board composition to shareholders in connection with their annual meetings regularly held in the late spring of 2004. Indeed, we expect that most if not all changes in corporate governance standards the SROs have proposed could be finalized and listed companies could act to implement them in this same time period. If, as we do not anticipate, an SRO has not adopted listing standards that comply with the Commission's rule under Section 301 by November 2003, the deadline for compliance should be extended so as to permit a listed company to make any necessary board composition changes at its 2005 annual meeting (recognizing that under the proposed rule the SROs must have adopted the required listing standards by March 2004, a deadline with which we concur).
There should be comparable time periods established for compliance by companies that report other than on a calendar year basis. In addition, we suggest that smaller companies be provided an additional period of roughly one year to come into full compliance, as we discuss below under "Issuers Affected - Small Businesses."
B. SROs Affected
Proposed Rule 10A-3(a)(5)(ii) establishes an aggressive 60 day timeframe in which the SROs must propose to the Commission for public comment and review listing standards in compliance with the rule's requirements for audit committees and section (a)(5)(iii) of the rule establishes a 270 day deadline by which the SROs must have adopted listing standards complying with the rule. While we support the Commission's efforts to have the rule proposals implemented as quickly as practicable, we are concerned that it may not be feasible for all the SROs to submit to the Commission proposed listing standards that comply with Proposed Rule 10A-3 within 60 days of publication of the final rule in the Federal Register. It may not be a problem for the NYSE , NASDAQ or the American Stock Exchange ("AMEX") to do so, but we recommend that the Commission give further consideration to allowing the smaller exchanges additional time to develop and submit their proposed listing standards 90 days after publication of the final rule in the Federal Register, as the smaller exchanges may not be nearly as far along in the process of developing new audit committee and other corporate governance listing standards as the NYSE, NASDAQ and AMEX. This may provide important flexibility for a smaller exchange which desires not to adopt the same standards proposed by the primary markets or to use the final Commission rule as a standard.
C. Securities Affected
The Commission has proposed that listed issuers of certain securities be exempted from the rule's requirements and requested comments on these exemptions and, in general, on the scope of applicability of the proposed rule to listed issuers. We recommend that the Commission narrow the application of its rule under Section 301 to exclude issuers who have listed only securities other than common equity. We recommend that the Commission consider further the applicability of the rule to foreign private issuers and address several matters regarding the manner in which such issuers may comply with the rule's requirements. We generally support the other exemptions the Commission has proposed but suggest clarification of certain aspects.
The Commission proposes to apply Rule 10A-3 to any security, debt or equity, listed on an SRO, subject to specific exemptions for debt securities of consolidated subsidiaries and additional multiple listings. The proposal represents a substantial expansion of audit committee mandates, which have been limited, even after the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees' recommendations,19 to companies whose common equity is listed. We believe the proposed application of the audit committee requirement to companies that do not have common equity securities listed is neither required by the Act nor necessarily in investors' interests.
The Commission cites reference to the phrase "any security" in Section 301 as the basis for extending the SROs' audit committee mandate to securities other than common equity. There is, however, little evidence to suggest that members of the Congress acting in the context of current SRO audit committee requirements found the existing mandate too narrow in its focus on common equity, or that it intended to broaden substantially the existing coverage of the SROs' rules. Indeed, there is no discussion at all of application of the mandate to debt issuers, which one would expect given the potential implications of such requirements on the exchange-traded debt market.
Historically, most corporate debt traded in the United States trades in the over-the-counter market. Of the estimated 22,000 publicly traded corporate bond issues in 2001, only 756, or 3.5%, were listed on the NYSE. Less than 10% of the approximately $2.7 trillion of corporate debt trades on an exchange market. Typically, even those issuers that are listed traded principally in the over-the-counter market, with exchange trades being relegated principally to odd-lot size.
The disparity in regulatory obligations between exchange and OTC traded debt, and the resulting disincentives to listing debt, is a long-standing issue.20 Proposed Rule 10A-3 not only would further broaden the regulatory gap between exchange and OTC traded debt, but in our judgment would be highly likely to cause many, if not most, of the issuers that would not otherwise be required to have an independent audit committee, simply to forego the benefits of a listing. For these debt issues, the efficiency and liquidity provided by exchange trading, used principally by retail and smaller institutions, would be lost. Clearly, the Congress did not intend to mandate that all issuers of public securities have an audit committee. To do so would have required a direct mandate rather than a mandate that applies only to SRO traded securities, which leaves most of the debt market outside the ambit of Section 301. For similar reasons, we suggest that the Commission also consider excluding from the audit committee requirements of Proposed Rule 10A-3 companies which have listed only "conventional" nonparticipating preferred stock, which is not convertible into common equity and does not vote in the election of directors except upon a default in payment of preferred dividends.
If the Commission, nonetheless, determines to require the SROs to extend audit committee requirements to securities other than common equity, we believe the exemptions proposed by the Commission for non-equity securities issued by a consolidated subsidiary whose parent is subject to the rules under 301, and for multiple listings, are necessary and appropriate. We suggest that both exemptions could, and should, be broadened without harm to the policies underlying the Commission's purpose in providing the exemption.
As discussed above, we believe that the rule should not mandate that companies that list securities other than common equity meet the audit committee requirements of Section 301. However, if this mandate is established, we believe the Commission's proposal to exempt issuers of listed non-equity securities from Proposed Rule 10A-3 is fully warranted where such issuers are consolidated subsidiaries. Most of these issuers do not have audit committees today and it would be of limited benefit to investors, as well as not cost effective, for issuers to undertake to implement a rule 10A-3 compliant audit committee.
The difficulties in finding individuals with the qualifications and experience required under Proposed Rule 10A-3 to serve on an audit committee of a subsidiary company cannot be overstated. Those individuals prepared to serve on audit committees and qualifying under Proposed Rule 10A-3 are in great demand to serve on true, publicly-owned companies; such individuals are highly unlikely to be interested in serving on a subsidiary company's audit committee. And, as the Commission recognizes in the Release, subsidiary security holders' interests will be served by the parent company's independent audit committee.
As proposed, the exemption for subsidiary securities other than common equity would require that the subsidiary be both majority-owned and consolidated, directly or indirectly, with the issuer subject to Proposed Rule 10A-3. We do not believe it necessary to require majority ownership if the entity is consolidated fully or on a pro rata basis; the parent company's audit committee will by reason of the consolidation provide the same degree of oversight. Likewise, we believe the rule should not preclude use of the exemption for debt by joint ventures, simply because the joint venture is not consolidated or majority-owned by the qualifying issuer. While these entities may not be consolidated or majority-owned, the owners of the entity typically contract to have at least substantial review and approval rights over the financial statements and financial reports of the joint venture that would provide sufficient control at the owners' level. These joint ventures are clear examples of the types of listed debt issuers, discussed above, that will simply give up listing their debt if the cost is having to create an audit committee complying with the requirements of Proposed Rule 10A-3.
Likewise, the requirement for majority ownership would preclude the use of the exemption by issuers of trust preferred securities, which are issued by a trust that is consolidated with and controlled by, but are not majority-owned by, a "parent" company. In footnote 74 of the proposal, the Commission indicates that it intends trust preferred securities to fall within the category of non-convertible, non-participating preferred securities that subsidiaries of listed companies could issue without becoming subject to the provisions of Proposed Rule 10A-3. We assume, therefore, that the Commission intends the exemption set forth in Proposed Rule 10A-3(c)(1) to extend to issuers of trust preferred securities, but we urge the Commission to clarify that consolidation rather than majority ownership is the appropriate test for exemption.
If the Commission does require issuers with SRO-traded debt to comply with the requirements of Proposed Rule 10A-3, we see no reason to limit the subsidiary debt exemption to those subsidiaries whose parent company Rule 10A-3 audit committee obligation arises solely out of its having SRO-traded common equity securities.
We believe that the Commission in providing an exemption under Rule 10A-3(c)(i) also should address the interplay between the exemption and the requirement under Rule 2-01(c)(7) that an issuer's audit committee preapprove audit and non-audit services. We believe it consistent with the purpose of the preapproval requirement under Sections 201 and 202 of the Act and the rationale for the proposed exemption under Rule 10A-3(c)(i) for the Commission to provide that an issuer exempt under Rule 10A-3(c)(i) may meet the preapproval requirement of Rule 2-01(c)(7), either by having its listed "parent" audit committee preapprove the audit and non-audit services for the exempt subsidiary issuer (or having such committee and the subsidiary's board provide such approval).
The Commission proposes to exempt multiple listings from Proposed Rule 10A-3, based on its judgment, with which we fully concur, that:
The Commission proposes to condition the multiple listing exemption on there being a class of listed common equity at the time of the additional listing. We see no reason for such limitation. The rationale for the exception and the costs of multiple compliance obligations remain equally compelling whether or not one of the listed classes is common equity. If the limitation arises out of the Commission's wanting to assure that where there are multiple listings that include a class of common equity, it is the common equity that is subject to Proposed Rule 10A-3, the rule should simply be revised to provide that the first class of common equity listed will not be entitled to the exemption and that a previously listed class of securities not eligible for the exemption would be exempt on the listing of the common equity.
We agree with the proposed exemption; requiring an audit committee would serve no investor interest at all.
D. Application of the Requirements to Certain Issuers
The Commission has proposed certain exemptions for foreign issuers, issuers of asset-backed securities and investment companies. We generally agree with the exemptions as we discuss more fully below. The Commission has also stated it does not "propose to entertain exemptions or waivers for particular relationships on a case-by-case basis." While we agree that the Commission should not be involved with granting individual exemptions or waivers, we strongly urge the Commission to clarify that each SRO will have the power to grant exemptions or waivers to listed companies as it deems it appropriate, including on a case-by-case basis to deal with particular extraordinary circumstances. Granting the SROs this power is consistent with the way the SROs have always interacted with their listed companies.
Section 10A(m) of the Exchange Act makes no distinction based on an issuer's size. Therefore, the proposed rule would apply to listed issuers of all sizes. The Commission seeks comments regarding the compliance burden for companies under a certain size and whether any accommodations for such companies are necessary.
We believe the principal problems posed by the proposed audit committee requirements for smaller companies involve locating, attracting and retaining a sufficient number of qualified persons to fill out their audit committees. Among the challenges facing smaller companies recruiting for positions on their audit committees include: (1) being less prestigious than larger, better established companies; (2) having lower levels of D&O insurance coverage; (3) having lower director compensation; and (4) confronting a general perception that the risks of shareholder litigation are higher.
It is difficult to ascertain the impact of the proposals on the thousands of smaller listed companies. We believe the most reasonable way to minimize the burden on smaller companies is to provide a reasonable transition period for such companies. Given an extended transition period, there would be the opportunity to learn more about the problems encountered by such companies and to make specific adjustments in the appropriate listing standards after examining those problems. The SROs could play a significant role in reporting on their experiences with the smaller companies. This would avoid current speculation as to impact beyond the obvious concerns that have been set forth above. It may be that no particular changes should be made. We suggest that the transition period apply to any company whose equity securities held by non-affiliates as of the end of its most recent fiscal year ending on the effective date of the Commission's rule has an aggregate market value of less than $75 million (a "Covered Company").21
We are proposing that a Covered Company be provided an additional year to come into full compliance; specifically that they be permitted until the second anniversary of the effectiveness of the SRO listing standard required by the Commission's rule under Section 301 to comply with the audit committee membership requirements of the listing standard. If, however, the SRO's audit committee listing standard is not adopted by November 1, 2003, the time for compliance for Covered Companies should be extended until its third annual meeting after adoption of the listing standard, specifically until its 2006 annual meeting. In addition, we suggest that the Commission clarify that its rule permits audit committees of Covered Companies to be comprised of fewer than three members who satisfy the audit committee member independence standards of the market on which it is listed.22
The Release reflects Commission sensitivity to the potential impact of reversing the Commission's and the SROs' long-standing deference to home country corporate governance standards and practices for foreign issuers. The proposal incorporates a number of provisions addressing the specific conflicts with home country requirements that have been identified by market participants and foreign regulators and reflects a reassuring level of Commission openness and responsiveness to the concerns of the foreign issuer community.
It is important, however, that the responsiveness of the Commission in addressing these identified conflicts not overshadow the need for the Commission to have an opportunity, with the participation of market participants, to engage in a thoughtful consideration of the fundamental policy and legal implications of imposing American corporate governance principles and mechanisms on companies organized under the laws of other nations. Proposed Rule 10A-3 is premised on a governance structure that is based on an American practice as defined by state corporate statute and common law fiduciary duties. To simply extract a board committee mechanism out of its American corporate law context and impose it into other corporate law systems that define the rights and duties of these corporate constituencies in widely varying ways raise real issues both as to the workability of the rules and, ultimately, their effectiveness. Little will be accomplished, and potentially much lost, if foreign issuers see the Section 301 audit committee as a compliance mechanism to be bolted onto their corporate governance structures to meet SEC requirements without being central to, or fitting within the reality of, their actual system of corporate governance.
Clearly, the rulemaking deadlines in the Act have not allowed the Commission the opportunity to consider these issues and to explore the implications of international companies being subject to varying governance standards of multiple jurisdictions. We believe that with the completion of the rulemaking mandated by the Act, the Commission should undertake a thoughtful wide ranging consideration of these fundamental issues with active participation of the broad spectrum of international market participants and regulators.
The Commission solicits comments as to the potential impact of having to comply with Proposed Rule 10A-3 on foreign issuers' willingness to list in the U.S. markets. Among the many concerns a foreign issuer has to overcome in deciding to enter the U.S. market, governance issues are likely to be key, particularly where they intrude on how a company is actually governed. Indeed, we think it is quite possible that concerns may grow with experience, if and to the extent the audit committee requirements begin actually to affect the governance of these companies. Certainly, the issue of the impact on foreign issuers' participation in the U.S. market would be a key issue to be considered under the proposed Commission international governance study.
The Commission notes in the Release "that some foreign jurisdictions continue to have historical structures that may conflict with maintaining audit committees meeting the requirements of Section 10A(m) of the Exchange Act" and encourages "foreign issuers that access the U.S. capital markets to continue to move toward internationally accepted best practices on corporate governance." We agree with the Commission that conflicts with foreign law and practices will remain and may present significant unanticipated difficulties. We think it critically important to the vitality of the Commission's program to attract international participation in the U.S. market that the Commission provide a mechanism whereby either the Commission or the SROs can address such situations and provide exemptions for companies which are subject to specified inconsistent foreign standards or waive compliance by a particular company with specific SRO listing standard requirements in unanticipated circumstances. Without the ongoing flexibility to address these conflicts, the Commission may unnecessarily preclude a foreign issuer from listing in the United States or create a perception in the international community of unresolvable impediments to listing.
As noted above, we believe the Commission has effectively addressed many of the specific conflicts identified to date. There are several refinements we believe necessary to fully accomplish the purpose of the various exemptions provided for foreign private issuers.
Most notable is the proposed exemption for statutory auditors in Rule 10A-3(c)(2). First, to qualify for the exemption, the foreign private issuer would have to be listed outside the United States. For those foreign private issuers already publicly traded in the United States without a foreign listing, this condition would compel them to seek an additional listing solely for purposes of qualifying for the exemption. This serves no apparent U.S. investor interest. Moreover, this requirement will preclude a foreign issuer from choosing to go public in the United States before listing in its home market, a result that seems not only unnecessary for the protection of U.S. investors, but indeed contrary to their interests. If this condition stems from concerns that American companies may seek to evade the full coverage of the proposed rule by changing their domicile, we believe the concern is not justified. The definition of foreign private issuer precludes foreign private issuer status, whatever the domicile of the company, where U.S. holders make up a majority of the shareholders and where (i) a majority of the executive officers or directors are U.S. residents; (ii) more than 50% of the assets are located in the U.S.; or (iii) the company's business is principally administered in the U.S. If this is not deemed by the Commission sufficient to protect against evasion, the rule could have a note, similar to other rules, making clear that the exception is not available for companies structured as foreign private issuers to evade the requirements of Rule 10A-3 (a possibility we think highly remote).
Second, and more problematic, Proposed Rule 10A-3(c)(2)(i)(E) could be read to require, as a condition of exemption, that a board of auditors or statutory auditor have a Commission-defined level of direct responsibility for the oversight of the work of any registered public accounting firm which has been engaged for the purpose of preparing or issuing an audit report concerning the listed company or providing similar audit, review or attest services (including responsibility for resolution of disagreements between management and the auditor regarding financial reporting). It is not clear whether the Commission intends to set in paragraph (E) an objective standard of responsibility that the foreign legal or listing provisions governing a board of auditors or statutory auditor must meet. If such is the case, we urge the Commission to specify the national laws and listing provisions that it considers would meet this requirement of the rule. If, on the other hand, the Commission intended that paragraph (E) require that a board of auditors or statutory auditor be "directly responsible" for the oversight of the public accounting firm to the extent required or permitted by home country legal or listing provisions, similar to the exemption provided by paragraph (F) with respect to appointment of a registered public accounting firm, paragraph (E) should be clarified.
The Commission solicits comment as to whether the exemption for statutory auditors should be subject to a mandatory sunset provision, and specifically requests comment on a sunset date of December 31, 2005. We strongly urge the Commission not to adopt a sunset provision for the statutory auditor exemption. To do so would certainly cause those listed foreign issuers that would have to rely on the exemption considerable concern and suggest that the exemption is not really an exemption but an extended transition period. Clearly, a sunset provision would encourage prospective new entrants to the U.S. market who would need to rely on the statutory auditor exemption to delay entry until after the exemption is reconsidered at the sunset date. As the Commission itself states in proposing the exemption for statutory auditors, "the establishment of an audit committee in addition to these bodies, with duplicative functions, might not only be costly and inefficient, but it also could generate possible conflicts of powers and duties." There seems little justification to select out this single aspect of the rule for a sunset provision.
Issues have arisen with respect to the exemption from the independence standard for government representatives or designees. There is a wide spectrum of types of government ownership of foreign private registrants, including those registrants whose equity is entirely owned by a foreign government. Limiting the government to a single position on the audit committee where it is the controlling shareholder and is likely to have substantive responsibilities with respect to the issuer may raise difficult issues for these governmental owners. Other issues that have been raised by foreign issuers involve questions as to what constitutes a "foreign governmental entity" for purposes of the exemption from certain independence requirements for designees of foreign governments.
Concerns also have been raised with respect to the exemption from the independence standard for significant shareholders. As the Commission notes in the Release, it is quite common for foreign private issuers to have significant shareholders. The limitation of the exemption to holders of over 50% will render the exemption unavailable to a number of foreign registrants with significant shareholders. In our experience, significant shareholdings that would be expected to be represented on an audit committee would be a level starting at about the 20% level. We believe that there is no investor protection reason to impose a minimum shareholding to qualify for the exemption.
We believe that granting observer status to a representative of a significant shareholder is not equivalent to granting actual membership on the audit committee. The committee of any board may invite such persons as it sees fit to participate in all or any part of its proceedings. Membership on the committee always enables the person to be a full participant with a voting right. We have no objection to the retention of the "no compensation" prong or to the requirement that a member not be an executive officer of the issuer or a chair of the audit committee. In this manner, foreign practices could be accommodated in a reasonable manner. Observer status does not achieve that result.
In its release, Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley Act of 2002, Release No. 33-8177 (Jan. 23, 2003), the Commission requests comment on the treatment of foreign private issuers with respect to financial experts in light of its implementing Section 301 of the Act.
With respect to audit committee financial experts, the Commission's Section 301 proposals raise a particular issue for foreign private issuers relying on the "statutory auditor" exemption. The Commission proposes to exempt foreign private issuers with statutory boards of auditors, or similar bodies, from requirements regarding the independence of audit committee members. We believe that this exemption should be extended to the disclosure requirements under Section 407 of the Act regarding the independence of the audit committee financial expert. Because statutory auditor duties generally are defined by home country standards, audit committee financial experts of such issuers are already subject to eligibility standards, including, independence requirements, under home country law. Requiring a foreign private issuer to disclose whether the person designated as the audit committee financial expert is independent under U.S. proxy rules while exempting from the independence requirements other members of the board of auditors means that foreign private issuers may be forced to consider different standards of independence among members of the board of auditors in satisfying their SEC regulatory requirements. In addition, we do not believe that persons designated as audit committee financial experts should be subject to standards of independence beyond those applicable to the full board of auditors. For this reason, we believe that foreign private issuers with statutory boards of auditors, or similar bodies, should be exempt from the disclosure requirements under Section 407.
In the event the Commission believes that these issuers should continue to be subject to the disclosure requirements under Section 407, we would suggest that the Instructions to Item 16A be amended to permit a foreign private issuer to designate an audit committee financial expert who is principally familiar with the GAAP such issuer uses to manage the company. We concur with the SEC's change in the final release permitting a foreign private issuer to appoint an audit committee financial expert principally familiar with GAAP used by the foreign private issuer in preparing its primary financial statements filed with the Commission. However, while this change addresses the situation of most foreign private issuers, by focusing on foreign private issuers' primary financial statements filed with the Commission, the Commission overlooks the circumstances of those foreign private issuers who use U.S. GAAP financials for their Form 20-F, but manage their company and maintain their books and records on a home country GAAP basis. We believe that, just as in the case of the foreign private registrant that reconciles its financial statements to U.S. GAAP, investors will be better served by a financial expert having in depth experience and expertise in the accounting principles and systems upon which the company is managed and from which are derived the home country financial statements that provide the foundation for constructing U.S. GAAP compliant financial statements.
We concur in the Commission's exclusion of asset-backed issuers from the proposed requirements. We recommend that the Commission expand the exemption proposed under paragraph (c)(5)(i) to include securities issued by royalty trusts23 and other comparable issuers that passively hold pools of assets and that do not have a board of directors or persons acting in a similar capacity. The definition of asset-backed issuers in Rule 13a-14(g) and 15d-14(g) does not cover the universe of issuer entities that have no active management and are not subject to the financial statement requirements applicable to most other Exchange Act registrants.
We believe that the proposed treatment of investment companies is well-founded and consistent with the public interest. Substitution of the "interested person" test for affiliation does, as indicated in the Release, effectively capture the broad range of affiliations that are relevant to independence. Furthermore, we concur that since Section 32(a) of the Investment Company Act provides for auditor selection by majority vote of the disinterested directors, the purpose of the audit committee requirement will be fulfilled. Therefore, since Section 32(a) functions effectively, no purpose would be served by substituting independent auditor selection or establishing a dual requirement that the audit committee nominate the independent auditor and a majority of the disinterested directors approve the independent auditor. Should experience with the application of these rules suggest future modification, action could be taken by the Commission at that time.
We also concur in the exemption for exchange-traded unit investment trusts.
E. Determining Compliance with the Proposed Standards
Proposed Rule 10A-3(a)(4) provides that SROs must require a listed issuer to notify the applicable SRO "promptly after an executive officer of the listed issuer becomes aware of any material noncompliance by the listed issuer with the requirements" of the Commission's rules. The Commission solicits comments on whether a listed issuer should be required to notify the SRO if it has failed to comply with the proposed requirements and if so, the Commission asks for guidance on how the mechanics of the notification should work.
We believe that the SROs should be given more latitude in structuring mechanisms to assure compliance with the listed company audit committee standards. The obligation to give notice to the SRO when an executive officer becomes "aware" of a violation is not a satisfactory procedure and not in the shareholders' interests. The information should be material and the proper recourse for that executive officer is to inform the audit committee or the board of directors so that appropriate internal corporate action can be taken. Furthermore, there should be an opportunity to receive interpretive or other advice from an SRO and to negotiate internally complying arrangements. Notice is the last resort because it could put a cloud on the company, affect the value of its stock and have an adverse effect on the business of the company. The concept of an opportunity to cure recognizes that a company should use its own resources and the experience of its directors in order to maintain compliance. Moreover, awareness is something less than a desirable standard.
We endorse the suggestion that in lieu of notification in the event of noncompliance, a listed issuer should be required to disclose periodically to the SROs whether they have been in material compliance with the standards. We believe an annual certification would also be appropriate. This would encourage an internal control system for compliance that is capable of realistic administration.
F. Opportunity to Cure Defects
Proposed Rule 10A-3(a)(3) provides that the rules of each SRO "must provide for appropriate procedures for an issuer to have an opportunity to cure any defects that would be the basis for a prohibition . . . [against initial or continued listing] before the imposition of such prohibition." The Commission inquires whether the SROs should be required to establish specific procedures for curing such defects apart from those they have already established with regard to delisting and, if so, the Commission asks for guidance on what these procedures should look like.
The opportunity for an issuer to cure any noncompliance with the proposed listing rules on audit committees is an extremely important protection for investors. Shareholders are the parties most harmed by any delisting. This has been true in the past and will be even truer in the future should listing requirements of the SROs become increasingly harmonized. If an issuer is delisted shareholders may no longer enjoy a liquid public market for their stock. Accordingly, the SROs should consider how to bring companies into compliance with listing requirements before instituting a delisting procedure. Further, because delisting is such a draconian sanction, other sanctions, such as reprimand, should be considered and included in the SRO rules. The time limits provided for curing defects also need to be flexible because some defects can be cured more quickly than others.
In the General Comments and Sections II.A and II.D above we discuss our suggestions regarding the timeframe in which the listing standards required by the proposed rule should become operative on listed companies. It would be appropriate for companies that are not in full compliance after the required deadline to disclose the extent to which they are not in compliance and what steps they are taking to come into compliance, and we suggest that the SROs should consider appropriate disclosure concerning these matters when addressing the provisions of their listing standards relating to compliance with, and the cure of violations of, the listing standards.
III. Disclosures Regarding Audit Committees
The Commission's proposal would require issuers to disclose their reliance on exemptions under the rule, with two exceptions. The Commission suggests that it is important for investors to know if an issuer is availing itself of an exemption. The proposed disclosure would go beyond simply noting reliance on an exemption and mandate disclosure "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 requirements of this section."
We believe, that given the nature of the exemptions provided in paragraph (b)(1)(iv) and paragraph (c) of the proposed rule, the proposed disclosures would not provide investors additional useful information, with one exception. We agree that companies relying on the exemption in paragraph (iv)(A) should include in their proxy statement disclosure concerning the independence of audit committee members and their reliance on and basis for the exemption. We believe this disclosure is appropriate, as the exemption is temporary and more in the nature of a transition provision. As to the other exemptions under paragraph (b)(iv) and the exemptions under paragraph (c), we do not believe investors would benefit from the proposed disclosures. It is inconceivable to us that any issuer will disclose that reliance on one or more of the enumerated exemptions would materially adversely affect the ability of the audit committee to act independently of management and to satisfy the requirement of the section. Thus, any resulting disclosure would be meaningless boilerplate.
Of further concern, this mandated boilerplate disclosure will fall disproportionately on foreign private issuers who are more likely to have to rely on various exemptions to comply with home country law, listing requirements or foreign practice. Form 20-F already requires a foreign private issuer to include disclosure concerning the company's audit committee and the terms of reference of the audit committee under Item 6C-Board Practices. Directors' business experience, both inside and outside the company, as well as any agreements pursuant to which a person was selected as a director also are required to be disclosed under Item 6A. We believe these disclosures provide adequate information about audit committee composition. The fact of reliance on a Commission exemption would add little to investors' understanding. For the same reason, we do not believe it necessary or appropriate to mandate that there be an exhibit requirement for those foreign private issuer registrants relying on the statutory auditor exemption. A foreign private issuer's use of statutory auditors will be adequately disclosed pursuant to Item 6C.
If, notwithstanding the foregoing, the Commission determines to require some form of the proposed disclosure, we recommend that the Commission in addition to excepting issuers relying on the exemptions for multiple listings and majority-owned subsidiaries under paragraph (c)(1) and for unit investment trusts under paragraph (c)(5)(ii), also except those relying on the following exemptions from the mandated disclosures as comparable to the Commission's proposed exclusions: (iv)(B) parent company independent directors; (c)(3) security futures products; (c)(4) standardized options; and (c)(5)(i) asset-backed issuers.
Pursuant to Proposed Item 401(h)(2) of Regulation S-K, an issuer's disclosure would need to appear in, or be incorporated by reference into, all annual reports that are filed with the Commission. In addition, such disclosure would need to be in proxy statements or information statements for shareholders' meetings at which elections for directors are to be held. The Commission solicits comments on the appropriate place for disclosure of basic information about an issuer's audit committee. We believe the location of this disclosure in the proxy statement is most appropriate. We also believe that if the entire board is acting as an audit committee, this should be disclosed, as it would be useful information to shareholders and investors. Furthermore, we believe that if the issuer does not have a separately designated audit committee, or committee performing similar functions, it would be appropriate and useful for the issuer to provide disclosure of the same information required of audit committee members for all the directors.
The Commission also asks for guidance regarding a non-listed issuers' ability to choose from one of the NYSE's, AMEX's or NASDAQ's definitions for audit committee members. We believe that non-listed issuers should select from one of the SRO's definition of audit committee member.
Finally, we believe there is more than adequate disclosure of material information and do not believe any additional disclosure is necessary.
We hope that these comments will be helpful to the Commission and its Staff. We would be pleased to discuss with the Commission or its Staff any aspect of this letter. Questions may be directed to Stanley Keller (617) 239-0217 or Robert Todd Lang (212) 310-8200.
cc: Hon. William H. Donaldson
Hon. Paul Atkins
Hon. Roel Campos
Hon. Cynthia A. Glassman
Hon. Harvey Goldschmid
Alan L. Beller, Director
Annette L. Nazareth, Director
Paul Roye, Director
Martin Dunn, Deputy Director