Brian T. Borders
Attorney at Law
1747 Pennsylvania Avenue, NW,
Washington, DC 20006
( 202 ) 296 - 8420
fax (202) 296--8494
November 30, 1999
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington D.C. 20549-0609
Re: Comments of the National Venture Capital Association on new SEC Audit Committee Rules: File no. S7-22-99
Dear Mr. Katz:
This letter is submitted on behalf of the National Venture Capital Association ("NVCA" or "the Association") to comment on the above-captioned Release.
Attached to this letter is an NVCA comment letter, filed November 12, 1999, on the new listing standards relating to audit committees. Since some issues addressed in that letter are also presented by this Release, the attached letter is incorporated by reference.
NVCA member firms provide the start-up and development funding for many companies that go public. Not all venture-backed companies succeed and fewer still become publicly traded. However, some companies that received venture capital support are now household names. Once funded and nurtured through their early stages, these companies have provided once-in-a-lifetime investment opportunities for individual investors, pension funds, charitable foundations and the investing public at large. Moreover, the engine of economic growth has received tremendous benefits from the willingness of venture capital investors to place long-range investments in early-stage enterprises.
At the same time they invest, venture capital firms usually commit the time and talent of their professional staff to assist in the governance of the enterprise. From their positions on the boards of pre-public and newly public firms, venture capitalists have gained significant insights into the proper role and functioning of audit committees. They also understand the importance of good members to a well-functioning audit committee. It is from this perspective that the NVCA comments upon the proposed new rules.
Basic NVCA Position
Generally, the new disclosure requirements, in combination with the new listing standards will have significant impact on pre-public companies. NVCA believes that the new SEC disclosure requirements will add to the effect of the new listing standards in narrowing the pool of available audit committee candidates. The Association is especially concerned with the new requirements for an audit committee statement regarding the audited annual financial report. This statement, like the new listing standards on financial acumen, will increase the risk, or at least the perceived risk, of legal liability from audit committee service. This will substantially increase the difficulty of recruiting good audit committee members.
NVCA is certain that the impact of these new requirements will be substantial on companies in the pre-public and early IPO stages. The Association does not believe that these new requirements will improve the quality of financial reporting in ways that will justify the expense and difficulties they create. Therefore, NVCA would prefer that the SEC forgo these new disclosures. However, on the assumption that the new disclosures are inevitable, the Association requests consideration of its recommended modifications.
I. New Disclosures in the Proxy Statement
a. The Audit Committee Statement Regarding the Financial Report
The NVCA's concerns are most acute regarding the new requirement that the audit committee state whether "anything has come to the attention of the members of the audit committee" that "caused the audit committee to believe" that the audited financial statements contain an untrue statement/misleading omission regarding a material fact. The Association appreciates that this language represents an effort by the SEC staff to address strong criticism of the Blue Ribbon Committee recommendation that audit committees be required to state a belief that the financial statements were "in conformity with GAAP."
The Association also notes that the Release would create safe harbor protection for this new disclosure by the audit committee. However, the two safe harbors would apply only to liability for negligence. The most feared and common suit is the securities fraud class action. The proposed safe harbors do not address this. The protections against negligence actions in the safe harbors are meaningful; however, their failure to address fraud suits--especially private actions for fraud--gives no protection against the audit committee member's most obvious risk. Nor do the safe harbors address cases charging directors' breach of fiduciary duty under state law.
Based on years of experience fighting frivolous securities class action litigation, the NVCA believes that these new disclosures will attract allegations of recklessness on the part of the audit committee in cases where a company's audited financial statements need to be restated. In the securities fraud class action litigation business, more civil actions are filed every year. With the passage of reform legislation, financial reporting has become the new focus of the securities class action bar. Therefore, any new statement regarding financial statements inevitably invites allegations that the statements were made in violation of Rule 10b-5.
The fact that the audit committee is required to make the statement will make it more difficult to attract good audit committee members to small and growing companies. Much like the "financial literacy" requirements in the new listing standards, this new requirement raises both the specter of new liability, and the perception of new liability for audit committee members. In particular, this requirement heightens concerns about personal liability of the audit members for alleged intentional or reckless misstatements.
The SEC position in the W.R. Grace case, which the Release cites to support this new disclosure standard, will heighten potential audit committee members' sensitivity to liability. The need to state the audit committee's collective belief regarding the financial statements calls attention to the liability the SEC asserted in the Grace case. While making committee members fully aware of their exposure is no doubt a goal of the new disclosure, it will certainly do more harm than good for getting good audit committee members.
Regarding state law liability, the benefits of the "business judgment rule" apply only in litigation. They do not deter efforts to extort settlements from boards of directors based on allegations that individual audit committee members breached their fiduciary duties. The existence of the Caremark decision, which the Release cites, will only encourage this type of suit and only heightens the concerns with such liability.
In short, while the liability potential of this new requirement is not fully understood, the practical problem of audit committee recruitment remains. Companies seeking audit committee candidates must deal with the perception of increased liability. These new disclosures will not escape the notice of the class action lawyers, and good audit committee candidates know it. The prospect of being vindicated in court will be little comfort to them.
b. Alternative Formulations of the Statement
Whether any alternative formulation of the required statement would lessen the risk of new liability is a technical legal question. No doubt excellent litigators would disagree on the best formulation. Indeed, it would be preferable to leave it up to each company as to which of the various proposed formulations it will use. Then, at least, over the long term the least risky formulation will become the standard statement. This approach seems preferable to simply picking one formulation and waiting for the prolonged development of case law to tell us if it was a good, or a bad choice. Therefore, the NVCA recommends that the final rule contain various formulations of the same statement as options, any of which an audit committee may use to fulfill this requirement.
c. The Audit Committee Report on its Procedures
As to the other three elements of the required audit committee report, NVCA believes that the required audit committee report is an effort by the SEC to write rules on corporate governance and that it infringes on the discretion of the corporate board to determine the best way to organize itself and its committees. The Association, therefore, opposes those requirements. Proxy materials already include a significant amount of disclosure that distracts investors from the real purpose of the proxy materials, which is to inform the investors of key matters within the purview of shareholders. The means whereby the board, in the exercise of its broad discretion, chooses to task the audit committee is not a concern of most shareholders. Those shareholders who concern themselves with such matters tend to already know every aspect of the company's corporate governance. Therefore, the NVCA opposes these new requirements.
d. Disclosures Regarding Corporate Charters
The requirement that the audit committee disclose the existence and the content of a formal written charter will cause most companies to, pro forma, adopt a charter. Regarding its disclosure, the same concerns with cluttering the proxy stated in c., above apply here. Therefore, the Association opposes these new disclosures as unnecessary and counterproductive to the purpose of the proxy.
II. Disclosure of a Lack of "Independence" of Audit Committee Members
The Association is most concerned that interpretation of the Nasdaq listing standards definition of "independent director" does not inhibit audit committee service for representatives of a company's venture capital investors. NVCA therefore, reiterates the request it made in its comment on listing standards, attached, that the SEC clarify this rule in the manner stated there at Part I. If the matter cannot be addressed in the context of the Nasdaq rule, the Association request clarification in the language of this new disclosure requirement, or in the SEC's enacting release.
III. Partial Exemptions for Small Businesses
NVCA has urged in Part IV of the attached comment letter that the Nasdaq adopt the $50 million revenue test proposed in the "aircraft carrier" as the proper threshold for its "SB" exemptions to certain listing standards. The Association urges a similar expansion of the "SB" exemptions to the disclosure rules. However, the new disclosures proposed in this Release will still add substantial new burdens for smaller and newer companies. For this reason, the Association urges the SEC to seriously consider a transitional period to apply to all IPOs as set out below.
IV. Transition Period for Newly Public Companies' Disclosures Regarding Audit Committee "Independence" And Charter
As indicated in Part V of the attached comment letter on listing standards, the NVCA believes that additional transitional relief should be provided for all newly public companies going forward after the expiration of the proposed eighteen-month Nasdaq listing standard transition. The reasons for this transition are also set out there. The Association recommends a similar eighteen-month transition before newly public companies are required by the SEC to make the related disclosures. Otherwise, any transitional relief obtained in the new listing standards would be of limited value. Therefore, NVCA recommends that the disclosures regarding a committee member's lack of independence, and regarding an audit committee charter not be required until eighteen months after the company goes public.
The NVCA opposes these new audit committee disclosure requirements. However, in recognition of the likelihood that they will be adopted, the Association strongly recommends the following changes or clarifications discussed above: (1) that companies be given a variety of formulations for the required audit committee statement regarding the audited financial report; (2) that the SEC clarify in writing that the normal relationship between a venture capital investor and the company is excluded from audit committee disqualifications based on independence; (3) that the SB exemption for these disclosure rules be expanded to $50 million; and (4) that the rule include a permanent transition period of eighteen months for IPOs to come into compliance with disclosures on independence and audit committee charters.
Finally, the Association strongly recommends that the Commission systematically review the effects of these new requirements to determine if they have had the desired effect or the unintended and detrimental effects that the NVCA and other critics predict.
I thank you for your consideration of NVCA's comments and request. Please feel free to contact me if I can be of assistance in this matter.
Very Truly Yours,
Brian T. Borders /s/
Brian T. Borders, Esq.
For The National Venture Capital Association