New York State Bar Association
One Elk Street
Albany, New York 11207
November 19, 1999
Securities and Exchange Commission
450 Fifth Street N.W.
Mail Stop 6-9
Washington, D.C. 20549
E-mail address: firstname.lastname@example.org
Attention: Jonathan G. Katz, Secretary
Re: Securities Exchange Act Release No. 34-41987
Ladies and Gentlemen:
The Committee on Securities Regulation of the Business Law Section of the New York State Bar Association appreciates the opportunity to comment on Release No. 34-41987, dated October 7, 1999 (the "Release").
The Committee on Securities Regulation (the "Committee") is composed of members of the New York Bar, a principal part of whose practice is in securities regulation. The Committee includes lawyers in private practice, in corporation law departments and in government agencies. A draft of this letter was circulated for comment among members of the Committee and the views expressed in this letter are generally consistent with those of the majority of the members who reviewed the letter in draft form. The views set forth in this letter, however, are those of the Committee and do not necessarily reflect the views of the organizations with which its members are associated, the New York State Bar Association, or its Business Law Section.
We commend the efforts of the Commission to improve the quality of financial accounting and reporting through improvements in corporate governance that will strengthen the audit committee and the role it plays in the financial reporting process. We support the purposes of the Release and we concur in the conclusions of the Commission that a properly functioning audit committee can help to enhance the reliability and credibility of financial reports. On the whole, we support the proposals contained in the Release and the recommendations of the Blue Ribbon Committee. We are concerned, however, that a number of the proposals do not adequately address the recognized risk that if audit committee members are exposed to unnecessary potential liability, the proposed reforms may not achieve their intended result. If the risk of liability or the exposure to unfounded claims makes it more difficult for companies to attract and retain qualified directors to serve on audit committees, the ultimate effect of the new regulations may be to reduce rather than enhance the effectiveness of audit committees in general. Fortunately, with respect to the Commission's proposals, we believe there are only a limited number of areas where this issue has not been adequately addressed. As more fully discussed below, we are principally concerned that the audit committee report as proposed exposes audit committee members to undue risks of liability and that the proposed safe harbor does not adequately shield them from that exposure.
The Audit Committee Report
Proposed new Item 306(a) of Regulations S-K and S-B, and Item 7(e))(3) of Schedule 14A, provide for the inclusion of an audit committee report in the company's proxy statement. The first three items of the report are procedural in nature and, we believe, are consistent with the proper objective of the report to describe the process followed by the audit committee in performing one of its principal functions, that of reviewing company's financial statements. Proposed paragraph (a)(4) of the rule, however, would require the audit committee to characterize the company's financial statements and state whether "anything" came to its attention which caused the committee to believe that the audited financial statements were misleading. Unfortunately, we do not believe that the changes made from the proposals of the Blue Ribbon Committee adequately reduce the risk of potential liability for audit committee members. By requiring the audit committee to make an affirmative statement concerning the quality of the financial statements, the members would now be exposed to potential liability under Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act") if a plaintiff alleges that the disclosure was incomplete. This aspect of the proposed report is not merely improved disclosure about the audit committee and its process. On the contrary, the audit committee is now being asked to give "cold comfort", thereby exposing itself to potential liability under both federal and state law.
We do not believe that the proposed disclosure in paragraph (a)(4) would provide sufficiently useful information to shareholders to warrant the increased exposure to liability or that this item of the report would reinforce the audit committee's awareness and acceptance of its responsibilities. We believe that, as suggested in the Release, the Commission should require disclosure only as to the activities, processes and/or discussions of the audit committee rather than its conclusions. As to the alternative formulation referred to in the Release, we believe that the proposal for the audit committee to state whether it is aware of any material modifications that should be made to the audited financial statements presents the same problem as the initial proposal. On the other hand, it would be totally appropriate for the audit committee to state that, based on the reviews discussed in paragraphs (a)(1), (2) and (3), the audit committee recommended to the full board that the audited financial statements be included in the company's annual report on Form 10-K.
In order to address the fact that the proxy statements of many companies often are prepared well in advance of the filing of the Form 10-K, there should be provision for an alternative formulation that would permit the audit committee to refer to the financials in the annual report to shareholders accompanying the proxy statement where the Form 10-K has not yet been filed.
With respect to proposed paragraph (a)(4), it should further be noted that even the independent auditors do not refer to financial statements in terms of untrue statements of material fact or omissions to state material facts necessary to make the statements not misleading. The report of the auditor always is stated in terms of whether the financial statements fairly present the financial condition or results of operations in all material respects. Further, with respect to negative assurance, the reference to "anything" is far too broad. If such a formulation were to be used, we think it would be preferable to refer to whether "any fact" has come to the attention of the audit committee that would lead it to have reached a particular conclusion.
We concur with the decision of the Commission not to require the signatures of the audit committee members to accompany the report. We also concur with the conclusion to include an audit committee report in the proxy statement rather than the annual report to shareholders or the Form 10-K. We believe the disclosures concerning the audit committee are more properly framed in relation to the election of directors. For companies that are not subject to the proxy rules, they should be required to include the information in the Form 10-K unless they have included the audit committee report in a proxy statement furnished to shareholders notwithstanding that the company was not subject to Regulation 14A.
The Safe Harbor
We concur in the recommendations of the Blue Ribbon Committee and the Commission that the audit committee be afforded a "safe harbor" covering to the required disclosures. Proposed Items 306(c) and (d) of Regulations S-K and S-B, and Item 7(e) (3) (v) of the proxy rules, would provide a safe harbor comparable to that applicable to the compensation committee report required in proxy statements under Regulation 14A. Because of the significant difference between the compensation committee report and the audit committee report, however, we believe that the safe harbor for audit committees should go further than proposed. The principal deficiency in the proposal is that the safe harbor would not shield audit committee members from claims under Section 10(b) of the Exchange Act. Unless protection from Rule 10b-5 claims is afforded to members of the audit committee for the disclosures required in the proxy statement or the Form 10-K, it may be extremely difficult to convince existing or prospective audit committee members that they are not being unduly exposed to potential liability under the federal securities laws. As a result, it may prove difficult if not impossible to attract qualified directors to serve on boards and audit committees.
In order to more effectively protect audit committee members from unnecessary exposure to liability we believe the safe harbor should be strengthened. Since the audit committee will be making an affirmative statement in the proxy statement regarding its role in the financial reporting process, a plaintiff will now be able to allege that this statement itself was recklessly made. The proposed audit committee report leaves audit committee members open to that kind of allegation in the event that information about a potential problem did come to their attention even though determined (in good faith and based upon information and advice that they thought was reliable) that the problem had been sufficiently acted upon. If an accounting irregularity is later detected in this area, audit committee members could be subject to a claim that they ignored the alleged "red flags" and that the statement as to their beliefs was reckless.
To remedy these concerns, we recommend that the Commission provide a safe harbor equivalent to that provided for "forward-looking statements" in the Private Securities Litigation Reform Act of 1995, which raised the standard for scienter to actual knowledge of the fraud as distinguished from recklessness. We believe that the policy concerns which led to the special standard for forward-looking statements is equally important in protecting audit committee members. If the threat of potential liability dissuades qualified people from serving on audit committees, the very foundation of the audit committee reform process will be significantly weakened.
Under no circumstances do we believe that the Commission should shorten the filing deadline for Form 10-Q. Further, although it is common practice for most companies to file their earnings releases on Form 8-K promptly after announcement, we do not believe that this practice should be mandated by Commission rule. Similarly, we do not believe the Commission should require that a report on the independent auditor's review be mandatorily filed.
* * * * * * * * * * * * *
We hope that the Commission will find these comments helpful. The undersigned would be available at the Commission's convenience to discuss further any aspect of these comments.
COMMITTEE ON SECURITIES
By: Guy P. Lander
Guy P. Lander
Chairman of the Committee
Gerald S. Backman
Richard E. Gutman
Michael J. Holliday
cc: Hon. Arthur Levitt
Chairman, Securities Exchange Commission
Hon. Paul R. Carey
Hon. Isaac C. Hunt, Jr.
Hon. Norman S. Johnson
Hon. Laura Simone Unger