Cravath, Swaine & Moore
One Ropemaker Street
London EC2Y 9HR
England

S7-02-03
Sarbanes-Oxley Act § 301
Standards Relating To Listed Company Audit Committees

February 18, 2003

Dear Mr. Katz:

This letter relates to the proposed adoption by the Securities and Exchange Commission ("SEC") of rules under Section 301 of the Sarbanes-Oxley Act of 2002 (the "S-O Act"). We are providing comments on five aspects of the proposed rules that we believe should be modified to more closely align the rules with the purposes of the S-O Act or require technical amendments, as described below:

• The proposed definition of "affiliate," which has been taken from other contexts, creates an overly broad presumption of non-independence; a more refined test should concentrate the focus instead on improper relations with management.

• Independent directors of affiliates should not be disqualified from serving on the issuer's audit committee.

• A more "neutral" disclosure requirement should apply to foreign private issuers in respect of exemptions from the audit committee rules.

• The prohibition on directors receiving compensation outside of their capacity as directors should clarify the categories of covered institutions and should include an exception for immaterial indirect payments.

• Issuers filing on Form 18-K should be exempt from the proposed audit committee rules.

I. The proposed definition of "affiliate," which has been taken from other contexts, creates an overly broad presumption of non-independence; a more refined test should concentrate the focus instead on improper relations with management.

We believe that the purposes of the S-O Act would best be served if the terms "affiliate" and "affiliated person" were directed primarily at disqualifying persons from serving on audit committees who have improper relations with management of issuers. By borrowing exclusively from concepts developed in other contexts, the proposed rules create an overly broad presumption of non-independence that will needlessly disqualify directors from serving on audit committees if they have relations with any significant shareholder. Under the proposed rules, a director cannot serve on the audit committee if he or she is an "affiliated person" with relations to an "affiliate" of the issuer, and an affiliate of an issuer is defined as any person that "controls, or is controlled by, or is under common control with," the issuer.

This aspect of the proposed rules is not fully consistent with the legislative history and goals of the S-O Act or the SEC's objectives described in the proposing release, which provide that audit committees are expected to serve the interests of shareholders, while audit committee members are expected to remain free of the influence of management. Senator Paul Sarbanes stated that "provid[ing] for a strong public company audit committee ... makes it clear that the primary duty of the auditors is to the public company's board of directors and the investing public, and not to the managers. We provide that the audit committee members must be independent from company management."¹ Likewise, the discussion in the proposing release fully reflects Congress' focus on the audit committee's independence from management and highlights the importance of directors' loyalty to shareholders,² all of which suggests that the attention of the proposed rules to restricting relations between shareholders and audit committees is misguided.

The focus of the proposed rules on control and share ownership was adopted from other contexts that do not present the same sorts of concerns as those the audit committee independence rules are designed to protect against. For example, the proposing release references Exchange Act Rule 12b-2 and Securities Act Rule 144. In those contexts, the relevant definition generally operates to protect a non-affiliate purchaser or seller where an affiliate may enjoy an informational advantage over the non-affiliate. In those circumstances, it may be appropriate to presume that persons with minority blocks of shares as small as 10% may possess informational advantages that should be addressed through prophylactic rules, such as Section 16 and Rule 144. We believe these presumptions are too much of a "blunt instrument" for the audit committee rules, where the appropriate concern is independence from management and, as discussed below, we think there are advantages to all shareholders in having significant shareholders represented on audit committees. A large shareholder, with more money at stake, is in most circumstances more motivated to, and thus more likely to, root out management wrongdoing.

While one can accept that at some level of ownership and control a shareholder may be inferred to have an identity of interest with management, we think that inference should only arise where the shareholder controls a clear majority of the stock or otherwise has the ability to appoint management. In all other cases, the interests of large and small shareholders should be presumed to be the same in ensuring that management and the auditors are applying the requisite care and discipline in the preparation of the company's financial statements and its financial reporting. In any event, it is "throwing the baby out with the bathwater" to prohibit in all cases representatives of significant shareholders from serving on audit committees merely because of speculation (unsupported by any of the recent examples of alleged accounting fraud) that in some cases an identity of interest with management may lead the shareholders to inadequately supervise management.

We believe that the overly broad approach of the rule will weaken, not strengthen, audit committees. In our experience, persons affiliated with significant shareholders are very often the most effective members of the board and the audit committee. In some cases, they are professional investors with a broad experience in managing significant investments and dealing with management on difficult issues. More importantly, in the context of the matters supervised by the audit committee, their interests as shareholders are identical to the interests of every other shareholder. The fact that they may own more than 10% of the stock should not create any inference or presumption that they are unfit for service on the audit committee. Additionally, significant shareholders have concentrated resources and the proper incentives to monitor management, which could be compromised under the proposed rules. In our experience, the level of board involvement and supervision, as well as the sophistication in financial and accounting analyses, of the representatives of those firms who serve as directors of portfolio public companies of private equity investors, are the "gold standard" of corporate governance.

The proposing release provides no principled reason why shareholders are likely to be under the influence of the issuer's management. We note that the reports and studies cited by the proposing release do not support the way audit committee independence is defined in the proposed rules, but have instead focused on the audit committee's independence from management. Similarly, the NYSE governance proposals from August 2002 adopted an approach that focuses primarily on relations between directors and managers and concluded that "as the concern is independence from management, the Exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding."³

We believe that the proposed rule itself recognizes the inconsistencies that arise from applying the definition of "affiliate" from those other contexts without modification. For example, subject to various conditions, the release proposes a safe harbor for shareholders who hold 10% or less of a class of equity securities of the issuer, and an exemption with respect to majority or wholly owned subsidiaries. As a consequence of the control-oriented definition of "affiliate," combined with the safe harbor and exemption, shareholders with a mid-range of investment in an issuer (between 10% and 50% of a class of equity securities) have greater restrictions placed on them than shareholders with either greater or lesser investments in the issuer. This outcome defies logic.

We accept that any relationship between the issuer and a member of the audit committee (or any entity of which he or she may be an affiliate) should generally prevent the member from evaluating transactions between the issuer and that member (or such affiliate). We also accept that at some level these arrangements could be sufficiently material to the director to warrant a determination that they are not independent. However, we believe that any such determination would be so fact intensive that it ought to be left to the determination of the Board. It seems clear to us that the primary role of the audit committee, as an audit committee, relates to the financial disclosures of the issuer. Accordingly, a person whose interests in the issuer are clearly aligned with the shareholders as a whole should not be precluded from serving on the audit committee merely because of the possibility that a conflict of interest transaction between the issuer and the member (or an affiliate) could not be reviewed by that person.⁴

Specifically, we would suggest the following:

• A shareholder should be presumed to be an "affiliate of the issuer" for purposes of the rules only where it owns a majority of the capital stock entitled to elect directors or otherwise has the power to elect a majority of the directors.

• The rule should presume that all other shareholders are not affiliates of the issuer. If a specific safe harbor is to be established, it should be at a level of ownership far higher than 10%. While we welcome the certainty that a safe harbor provides, we are concerned that there will be a strong negative implication that shareholders above the safe harbor threshold are impermissibly "tainted." If the final rule sets a safe harbor threshold below 50%, it should also expressly include a favorable presumption for shareholder interests above that safe harbor and below the majority threshold.

• The fact that a shareholder has the power to elect (or nominate) one or more directors (but not a majority) should not preclude those directors from serving on the audit committee.

• The release adopting the final rule should specifically state that venture capital and other private equity investors can qualify as audit committee members under the rule so long they otherwise meet the requirements for audit committee membership.

• The final determination of independence should in all cases be left to the board of directors after giving appropriate consideration to any presumptions in the rule.⁵

• Any safe harbor for minority shareholders should not be conditioned on the relevant shareholder not being a director of the issuer. As proposed, that condition would disfavor natural persons, since natural persons are the only types of entities that could be both directors and shareholders of an issuer.⁶

II. Independent directors of affiliates should not be disqualified from serving on the issuer's audit committee.

Regardless of how the final rule addresses the basic concept of "affiliate of the issuer," we believe that directors who are independent of both an issuer and an affiliate of the issuer under all applicable independence requirements should not be disqualified from serving on the issuer's audit committee merely on account of the relationship between the issuer and the affiliate. A director who is independent of management of both entities could not be "tainted" by management of either entity on account of the affiliate relationship between them, because the director will have no improper relationship to management of either the affiliate or the issuer. However, under the proposed rules "any director," even an independent director, of an affiliate is deemed to be an "affiliated person" of the issuer and disqualified from serving on the issuer's audit committee.

The analysis set forth in the proposing release in connection with the "parent-subsidiary" exemption supports this position. The proposing release explains that a director who is independent of both an issuer and a parent or subsidiary affiliate should not be disqualified from sitting on the issuer's audit committee because "[i]f an audit committee member of the parent is otherwise independent, merely serving also on the board of a controlled subsidiary should not adversely affect the board member's independence, assuming that the board member also would be considered independent of the subsidiary except for the member's seat on the parent's board."

We agree with the reasoning in the release, and note that the logic of that analysis extends to all affiliates, not merely those that are majority owned by, or own a majority of, the issuer. Indeed, it is even more compelling for affiliations that are weaker than parent-subsidiary relationships. For example, an audit committee member who is also an independent director of a 20% owned joint venture would be less likely to be under the control of management than an audit committee member who is also an independent director of an 80% owned subsidiary, because the weaker affiliation would provide less control over, and less economic interest in, the relevant entity.⁷ We recognize that directors of two affiliated entities may have conflicts of interest when called upon to evaluate transactions between the affiliates, but as discussed above, that is separate from and generally should not affect the suitability of the director to remain independent of management and evaluate matters pertaining to the internal governance of each of the companies.

The proposed rules in this area would also create anomalous results if independent directors of affiliates are generally disqualified from serving on an issuer's audit committee. For example, although the proposed parent-subsidiary exemption would permit an audit committee member to sit on the board of a majority parent, no exemption would be applicable to permit him or her to sit on the board of any other affiliate of the issuer, even another majority owned subsidiary of a common parent. As a result, a qualified audit committee member would be prohibited from serving on the board of any "sister" subsidiary of the issuer, even if he or she is independent of the parent as well as all of its subsidiaries. In the context of an organization where there is a need for independent director audit committees at multiple related issuers, these results would make it unreasonably difficult for issuers to obtain a sufficient number of independent directors. Further, the proposed rules would permit an affiliated shareholder to place any employee or other person not covered by the definition of "affiliated person" on the audit committee of the issuer, whether or not that person was independent of the affiliate, while restricting directors who are independent of the affiliate from serving on the audit committee of the issuer.

III. A more "neutral" disclosure requirement should apply to foreign private issuers in respect of exemptions from the audit committee rules.

We believe that the proposed requirement that foreign private issuers state whether "reliance [on an exemption under the rules] would materially adversely affect" the audit committee creates an inappropriate presumption that audit committees of foreign private issuers do not conform to best practice standards and are not as effective as those of U.S. issuers. We recommend instead that the final rules require issuers to fully describe the unique features of their audit committee practices and explain how those features operate under the circumstances to serve the interests of investors. This type of "neutral" disclosure requirement would provide investors with the information they need to evaluate the audit committee structures of those issuers, without misleading investors regarding the effectiveness of those audit committee structures and without implying that "one size fits all" with respect to audit committee independence.⁸ We note that Congressional silence regarding the treatment of foreign private issuers under the S-O Act was not intended to deprive the SEC of its historical authority to treat foreign private issuers differently than U.S. issuers, especially in the case of rules that govern corporate governance practices rather than disclosure requirements.⁹

As stated above, the presumption created by the proposed disclosure requirements inappropriately suggests that foreign private issuers have derogated from best practice standards governing audit committees. In fact, by providing specific exceptions, the SEC is itself necessarily making a judgment that structures that qualify for an exemption meet the fundamental requirements of the S-O Act. To be clear, we have no objection to the requirement that every issuer must explain how its governance structure functions. That disclosure is entirely appropriate. We note that, in other contexts, the SEC's proposed rules have recognized that similar requirements to disclose non-compliance with the SEC's standards, even where those standards are not mandatory, could harm issuers.¹⁰

IV. The prohibition on directors receiving compensation outside of their capacity as directors should clarify the categories of covered affiliations and should include an exception for immaterial indirect payments.

We think that the key phrase "partner, member or principal or occupies a similar position" lacks clarity and can be read in an overly broad fashion, particularly when applied to a large diversified organization. The phrase itself suggests that it is intended to capture partners or members of a law firm, accounting firm or other professional association. It is not at all clear that it is also intended to cover employees of a large, diversified corporate organization. We would have assumed, for example, that a director of a bank or bank holding company would not in the ordinary case be captured by the rule. We also believe that this definition, given its purpose of identifying "indirect compensation," should not generally be applied to any member of the organization providing the service if that member's compensation was not directly affected by payments received from the issuer for the relevant services. Many issuers have persons who are also directors or senior executives of financial institutions on their boards. The proposed rule would appear to have the effect of prohibiting these people from serving as audit committee members. Otherwise, the financial institution may feel compelled to forego all opportunities to provide advisory services to the issuer and its subsidiaries.¹¹

A materiality-based exception from the restriction on directors receiving "indirect" payments outside their capacity as directors would benefit shareholders by permitting independent directors to continue to serve on audit committees in circumstances in which there is no material risk to the independence of their judgment. We are concerned that the absence of a materiality threshold could result in talented independent directors being ineligible for, or being required to resign from, audit committees on account of indirect payments that are immaterial to the director. While we agree that indirect payments to directors can affect the independent judgment of those directors and should be restricted, indirect payments that do not rise to a level of materiality for the director could not affect his or her independent judgment.

V. Issuers filing on Form 18-K should be exempt from the proposed audit committee rules.

We recommend that the final rules be clarified to provide that they do not apply to sovereign and other issuers eligible to file reports on Form 18-K ("18-K issuers"). It is clearly stated in the congressional record that it was not "the intent of the conferees to export U.S. standards disregarding the sovereignty of other countries as well as their regulators."¹² Since investors do not expect or rely on audit committee structures in the case of 18-K issuers, and because the proposed rules would be generally incompatible with the organizational structures or even the underlying legal framework of 18-K issuers, we believe that a general exemption is appropriate.

We do not believe that the SEC intended the audit committee rules to apply to 18-K issuers. We note that the proposing release does not express any specific intent to apply the audit committee rules to 18-K issuers, and the proposed rules would not make any amendments to Form 18-K. Similarly, the certification requirements under Section 302 of the S-O Act were not applied to reports on Form 18-K. Applying the audit committee rules to 18-K issuers is also not required by the spirit of the S-O Act, for which the impetus was the improprieties of corporate executives. However, as proposed, the audit committee rules would apply "not just to voting equity securities, but to any listed security, regardless of its type, including debt securities, derivative securities and other types of listed securities." Under this listing standard, the audit committee rules would technically apply to all issuers with listed securities, including 18-K issuers with listed debt securities.

The audit committee rules would not be compatible with the organizational structures of 18-K issuers, which generally do not have boards of directors, or audit committees, and may require constitutional amendments or similar changes to implement those rules. In addition, it often would not be possible (or if possible, appropriate) for 18-K issuers, in particular foreign governmental issuers, to locate directors who have no relations to, and receive no direct or indirect payments from, those 18-K issuers.

* * * * * *

Please feel free to contact William P. Rogers, Jr. (at +44 20 7453 1050 and wrogers@cravath.com) or Christopher S. Harrison (at +44 20 7453 1071 and charrison@cravath.com) regarding these comments.

Very truly yours,

William P. Rogers, Jr.

Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609

cc: Alan Beller
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609

cc: The Corporate Accountability and Listing Standards Committee
New York Stock Exchange, Inc.
11 Wall Street
New York, NY 10005

____________________________

1	Remarks of Sen. Paul Sarbanes, Banking Committee Chairman, on July 8, 2002, Cong. Rec. pages S6330-6333.
2	The release states, for example, that "[t]he board of directors, elected by and accountable to shareholders, is the focal point of the corporate governance system," and that "[a]n independent audit committee with adequate resources helps to overcome this problem [of management's self interest] and to align corporate interests with those of shareholders." The release also explains that the proposed rules permit shareholders, rather than the audit committee, to elect the auditor because the proposed rules "relat[e] to the assignment of responsibility ... as between the audit committee and management," not between the audit committee and the shareholders the committee is expected to serve.
3	Commentary to subsection 2(a) of the NYSE's proposed rules.
4	In the situation where the audit committee would otherwise evaluate such a transaction, it would be relatively easy for any conflicted member of the audit committee to be recused or for a different, independent committee to be utilized.
5	We believe that in appropriate cases even a majority controlling shareholder should be permitted to serve on the audit committee.
6	Consequently, the safe harbor would be available for legal entities, or natural persons who hold their shares indirectly through a legal entity, but would not be available for natural persons who hold their shares directly. We do not see, and the proposing release does not provide, any reason for disfavoring natural persons as shareholders in this context. For example, under the proposed safe harbor, a 10% shareholder that is a corporation, or natural person who holds his shares through a corporation, could have a representative of the corporation become a director and a member of the audit committee. That shareholder could be deemed under the safe harbor not to be an affiliate of the issuer, because the corporation would be a shareholder but not a director; and the representative could qualify as independent, because the shareholder it represents would be deemed not to be an affiliate. In contrast, a natural person who is a 10% shareholder could not qualify for this safe harbor. Because all audit committee members must be directors of the issuer, the shareholder would have to become a director before he or she would be permitted to serve on the audit committee. However, if that shareholder becomes a director of the issuer, he or she would no longer qualify for the safe harbor, because the condition to the safe harbor would not be satisfied. We also note that it would be possible under the rules for a natural person who is a shareholder to designate a representative to sit on the audit committee, although the shareholder himself or herself would be prohibited from sitting on the audit committee. Likewise, the condition under the parent-subsidiary exemption that a parent consolidate the accounts of its majority owned subsidiary will disfavor shareholders who are natural persons, since natural persons cannot consolidate accounts of entities they own shares of.
7	For the same reasons, an audit committee member who is also an independent director of a company that owns 20% of the issuer is as unlikely to be under the control of management as an audit committee member who also is an independent director of a company that owns 80% of the issuer.
8	In principle, the same problem also arises for U.S. issuers that rely on certain exemptions. However, it is a more significant issue for foreign private issuers, since all of the specific exemptions in the proposed rules are tailored to accommodate the circumstances of foreign private issuers.
9	Senator Enzi notes that "the SEC historically has permitted the home country of the issuer to implement corporate governance standards." Senator Enzi also encouraged the SEC to continue its historical practices in this respect: "Under the conference report, section 3(a) gives the SEC wide authority to enact implementing regulations that are `necessary or appropriate in the public interest.' I believe it is the intent of the conferees to permit the Commission wide latitude in using their rulemaking authority to deal with technical matters such as the scope of the definitions and their applicability to foreign issuers. I would encourage the SEC to use its authority to make the act as workable as possible consistent with longstanding SEC interpretations." Remarks of Senator Enzi, 148 Cong.Rec. S7350-04 *S7356.
10	For example, the adopting release under Sections 406 and 407 of the S-O Act concluded disclosure of non-compliance with the SEC's standards could harm issuers: "we recognize that a company that does not have an audit committee financial expert or a code of ethics that complies with these new definitions may be harmed by having to disclose these facts even if the company intends to obtain such expert or code."
11	We also request that the final rules make it clear that only compensation for advisory services are covered by the restrictions on direct and indirect compensation.
12	Remarks of Senator Enzi, 148 Cong.Rec. S7350-04 *S7356.