November 30, 1999
Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, N.W. Stop 6-9
Washington, DC 20549
Via e-mail: firstname.lastname@example.org
Re: The Audit Committee Disclosure Release
No. 34-41987; File No. S7-22-99
Ladies and Gentlemen:
The Securities Law Committee of the American Society of Corporate Secretaries is pleased to provide comments to the Securities and Exchange Commission on the Audit Committee Disclosure Release No. 34-41987, which proposes rules in response to the Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. The Society, with more than 4,000 members, represents over 2,700 public companies. We believe that our members, who serve as the interface between management, the company's directors and its shareholders, are in a unique position to provide insightful and discerning perspectives on the issues raised in the Release.
The Society shares the Commission's commitment to quality financial reporting and improving the effectiveness of corporate audit committees. We support your efforts to enhance the reliability and credibility of financial statements of public companies. We are in general agreement with most of your proposals and believe they will make for more effective audit committees. However, we believe several of the proposals would unduly increase legal liability of audit committee members and possibly discourage candidates from serving on the board of directors of public companies. For example, the audit committee report and the publication of the charter, are two proposals that we believe raise serious liability concerns without producing any corresponding benefits to the responsibility and credibility of financial statements.
A. Audit Committee Report
The Society cannot support the proposal that an audit committee report be added to the company's proxy statement, published over the names of each of the individual audit committee members.
The Society's opposition is based upon our evaluation of the most effective and appropriate role of the audit committee; intent of additional meaningful information provided by the report; the likely impact of the proposal on overall Board effectiveness; and the increased litigation exposure of audit committee members based on such a report.
We believe the audit committee's role is, and should remain, that of oversight and monitoring of a company's financial reporting process. The audit committee should be entitled to rely upon management and the outside auditors as to the accuracy of the financial statements. Management and the outside auditors are better positioned to be knowledgeable of a company's financials. This is consistent with state corporation law which permits reliance by the board on outside experts and employees of the corporation.
The Committee believes that the proposed report creates an inappropriate shift in responsibility for the financials and other disclosures away from management and the independent auditors and towards the audit committee. Financial management of the corporation, the internal auditors and the independent auditors each spend a large amount of time, utilizing many professionals, to analyze the underlying fundamentals and produce the financial statements and disclosures. An audit committee can review the processes, satisfy itself that appropriate and well-qualified people are in charge of the processes, and ask informed and probing questions, but it cannot be sufficiently informed as to certify, or give negative assurance, as to the quality of the company's disclosures. That is the proper role of management and the independent auditors. The audit committee should be independent and competent and should exercise care in its oversight functions, but it cannot and should not substitute its judgment for that of management or the independent auditors.
We believe that a likely result of the proposed report is that audit committee members will become targets of litigation more frequently. Based on this threat, we believe qualified director candidates will be deterred from serving on boards. If this were to happen, this proposal would have the opposite effect than intended by the SEC: it would lead to the deterioration rather than the improvement, in the quality of audit committee involvement in a corporation's financial process.
The proposed safe harbor, discussed later, is not comprehensive, and would not provide protection from an Exchange Act Rule 10b-5 claim or an action brought in state court.
The SEC is seeking comment on alternative formulations. We believe that a statement regarding material modifications provides no further information to investors and is merely stating the obvious. Although we would prefer no report for the reasons stated, if some report is deemed necessary, we would be more inclined to support an alternative that merely describes the process followed by the audit committee. We believe this requirement more closely parallels the audit committee's responsibility to oversee the financial reporting process, and presents less litigation risk than what is currently proposed. We believe anything other than a description of process, including whether the audit committee knows of material modification, would be inappropriate.
B. Charter Disclosure
Proposed Item 7(e)(3) of Schedule 14A would require companies to disclose whether their audit committee is governed by a charter and to include a copy in the proxy statement at least every three years. The release states that this requirement would help shareholders access the role and responsibilities of the audit committee and help focus committee members on their responsibilities.
The Society believes that this disclosure ought not be mandated as it does not materially expand the disclosures required by the current regulatory scheme. The proxy rules currently require disclosure regarding general responsibilities of board committees.
The Society also does not believe including the charter in the proxy statement is necessary to help shareholders assess the role and responsibilities of the audit committee. Disclosing whether a company has an audit committee charter and describing key aspects of the audit committee as currently required by Item 7(e) of Schedule 14A, will provide sufficient information to shareholders about the audit committee process and adequately focus audit committee members on their responsibilities. The Society respectfully opposes this proposal, which would add additional costs to the printing and distribution of a company's proxy statement, would place undue emphasis on the role of the audit committee and its charter relative to those of other committees of the board and their charters and, is unlikely to provide more useful information to investors.
This proposed disclosure requirement also could have several unintended adverse consequences. Attaching the charter to the proxy statement is likely to increase litigation risk without significant corresponding benefits. With regard to this increased liability exposure of audit committee members, proponents of the proposed rule have said that "increased responsibilities will lead to decreased legal exposure," based on the argument that under state law, "more active and involved" audit committee members would satisfy the business judgment rule under state corporate law and thus escape liability. The Society respectfully disagrees. Increased exposure to liability will be present despite audit committee members having acted in good faith and having been active and involved, if in hindsight it can be demonstrated that the audit committee members did not comply with the requirements of the audit committee charter. In litigation, the requirements of the audit committee charter itself will be subject to varying interpretations. More likely, companies will deliver boilerplate charters to better position companies against such litigation, which clearly is not the intent of the proposal. Requiring audit committees to disclose whether they have complied with the charter will further the risk of litigation. A better approach might be to have the outside auditor report to the board on whether all committee charters' have been complied with. This will alleviate both public disclosure and the threat of litigation.
As presently proposed, we believe this proposal will disrupt the proper functioning of boards. The real or perceived increase in exposure to liability will dissuade directors from serving on audit committees, or lead audit committee members to demand additional or different compensation than is received by their fellow board members.
C. Liability Safeharbor
The SEC has proposed a safeharbor for the new disclosures which would track the safe harbor for compensation committee reports. The disclosures would not be considered soliciting material filed with the SEC or be subject to the liability of Section 18 of the 1934 Act. In proposing the safe harbor, the SEC states it does not intend for the new disclosures to subject companies or their directors to increased liability or to create new fiduciary standards for directors under state corporation law.
We appreciate the Commission's intent to limit increased liability of directors as a result of these proposals. The proposed safeharbors should be adopted, although we believe they afford only minimal protection from the increased peril created by the proposals that neither the Commission nor the Society can wholly foresee nor effectively contain. We believe the safeharbors should apply even to those disclosures that are factual because the language in those provisions can be subject to interpretation, and the safeharbors can alleviate litigation that could be brought to challenge compliance with those provisions.
In terms of its effect, we are concerned that the proposed safeharbors will be of only limited benefit. The proposed safeharbors will not protect companies and directors from liability under the antifraud provisions of the federal securities laws and SEC administrative sanctions. To address this concern, the safeharbors might be expanded to protect any disclosures under the proposed rules that do not involve intentional wrongdoing. This would ensure audit committee members are not found liable under the federal securities laws for disclosures made in good faith.
We also note that the business judgment rule and ordinary care standards may be higher for experts under state corporation law than for non-experts. Consequently, directors' liability for breach of fiduciary duties under state law may be increased by the heightened financial literacy expertise standard coupled with the representations which would be required by proposed Item 306 of Regulation S-K.
Should the Commission insist on some form of audit committee report, we respectfully request that it consider establishing safeharbor protections that parallel those provided in the connection with the Private Securities Litigation Reform Act of 1995 and the Securities Litigation Uniform Standards Act of 1998.
D. Pre-Filing Independent Review of Form 10-Q.
Most of our members support a review of interim financial statements by independent auditors prior to filing of Form 10-Q or 10-QSB, provided that the content and extent of the reviews does not expand from what is currently required by SAS 71. We believe that such reviews can be helpful in ensuring that quarterly financial statements are reliable and credible. Interim reviews also may relieve some of the burden and time pressure of the year-end audit, as auditors will already be conversant with many of the significant issues expected to arise in connection with the year-end audit.
We understand that the major accounting firms are in most cases now requiring such reviews as a condition to acceptance of audit engagements. Thus, for many companies, the proposal will not add significantly to the burden and expense of auditor reviews. Yet, for those companies whose auditors currently do not perform SAS 71 reviews on interim financial statements, the requirement will add additional cost, especially in the early years. This additional cost could be significant.
Should the Commission decide to impose mandatory quarterly reviews, we recommend that this requirement be effective for all interim periods beginning on or after December 15, 2000. A delayed effective date would permit all companies adequate time to establish processes and procedures necessary to implement this proposal.
While we believe that a "level playing field" is best for all investors, we recognize that the additional burden could be significant for some small companies. We would therefore urge an exemption or extended phase-in period for small businesses. We suggest that the Commission utilize the pre-existing criteria of Section 302(a)(5) of Regulation S-K as an appropriate test for the imposition of this requirement.
We do not support the Commission's proposal to require a SAS 71 pre-filing review for interim financials in registration statements. Such a requirement goes beyond the main impetus of the proposal, which is ensuring the integrity and quality of quarterly reports. Interim financials included in registration statements typically are reviewed in detail by auditors and, frequently, by underwriters and their counsel. The timing of other reports is unpredictable, and requiring SAS 71 reviews could result in significant delays in the context of a rapidly moving transaction.
In addition, we do not support a requirement for a SAS 71 review prior to quarterly earnings releases. It may be a "best practice" to have audit committee discussions prior to release of earnings; however, in some instances, it may not be practicable. Many companies work with their auditors to resolve all issues and potentially problematic accounting judgments prior to the release of earnings. What is not typically available prior to the release of earnings are the full financial statements. While the Society supports the prompt release of earnings, it urges the SEC to adopt a "best practice" approach for an SAS 71 review prior to quarterly earnings releases.
We believe there should be a significant transition period to these proposals and that such rules should not be effective in 2000. Companies must have a fair opportunity to consider the implications of the final rules and revise their audit committee procedures prior to making disclosures. Companies need time to fully implement the processes that will be required. Moreover, the adoption of the proposed rules could prompt widespread resignation of audit committee members and companies would require time to recruit and orient their replacements.
The Society thanks the Commission for this opportunity to comment on the Release. If you have any questions on our views, please let us know.
Margaret M. Foran
Securities Law Committee
Michael J. Holliday
Corporate Audit Committee Task Force
Kathleen A. Weigand
Corporate Audit Committee Task Force
cc: The Honorable Arthur Levitt
The Honorable Norman S. Johnson
The Honorable Isaac C. Hunt, Jr.
The Honorable Paul R. Carey
The Honorable Laura S. Unger