December 3, 1999
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20459
Attention: Jonathan G. Katz, Secretary
Re: Audit Committee Disclosure (File No. S7-22-99)
Ladies and Gentlemen:
The Committee on Federal Regulation of Securities and the Committee on Law and Accounting (the "Committees") of the Section of Business Law of the American Bar Association submit this letter in response to the Securities and Exchange Commission's request for comments on Audit Committee Disclosure, Release No. 34-41987 (October 8, 1999) (the "Proposing Release"). The Committees have an aggregate membership of over 2000 securities lawyers who practice as inside and outside counsel and who represent thousands of publicly held companies and a number of independent public accounting firms.
A draft of this comment letter was circulated for comment among numerous members of the Committees and the Section and received the general agreement of a majority of those who responded. This letter, however, does not represent the official position of the American Bar Association, the Section of Business Law, or the Committees, and does not necessarily represent the views of all who reviewed it.Summary
The Committees support the Commission's goal of improving the quality of financial reporting by public companies. We concur that focusing on effective operations by audit committees can contribute toward achievement of this goal.
We support, in principle, review of interim financial statements by outside auditors. However, the Committees believe that the Commission's proposal to require review by outside auditors of interim financial statements may exceed the scope of the Commission's authority under the Securities Act of 1933, as amended
(the "1933 Act") and the Securities Exchange Act of 1934, as amended (the "1934 Act"). We believe it may be more appropriate for such requirement to be imposed by the national securities exchanges and Nasdaq with respect to the interim financial statements of issuers with securities listed or admitted to trading in those markets, and clearly would be within their authority.
The Committees do not have strong objections to certain of the proposed disclosures regarding the activities undertaken by audit committees, although we question their utility. However, the Committees strongly object to the Commission's proposal to require audit committees to express "negative assurance" with respect to their Company's financial statements because it would expose members of audit committees to potentially serious liabilities, and because the proposal could undermine the protection afforded to directors under substantially all state corporate laws.
The Committees also believe the proposed rules should not apply to closed-end investment companies, in view of the unique governance standards mandated by the Investment Company Act of 1940, as amended and the Commission's separate consideration of appropriate governance standards for registered investment companies.Discussion
Proposal for Auditor's Review of Interim Financial Statements.
The Commission proposes to require that interim unaudited financial statements included in Quarterly Reports on Forms 10-Q and 10-QSB be reviewed by independent auditors in accordance with Statement on Auditing Standards No 71, "as may be modified or supplemented by the Commission," prior to filing with theCommission. (Proposed Rule 10-01(d) of Regulation S-X; proposed Item 310(b) of Regulation S-B). The Commission also asks whether this requirement also should apply to interim unaudited financial statements included in registration statements filed under the 1933 Act or the 1934 Act
The Committees believe that the involvement of independent accountants in the reporting of interim financial data should result in improvement in the quality of interim financial statements. However, many members of the Committees have serious questions about the Commission's authority to require issuers to obtain such a review in connection with filings under the 1933 Act or the 1934 Act, and, therefore, believe that this requirement is better dealt with by stock exchange and NASD rules.1 Section 13 (a)(2) of the 1934 Act, which establishes the Commission's authority to require the filing of periodic reports by issuers, authorizes the Commission to require annual reports "certified... by independent public accountants, and such quarterly reports as the Commission may prescribe". No authority is specified with respect to review of quarterly reports. Similarly, Schedule A to the 1933 Act authorizes the Commission to require a "certified" balance sheet as of a date not more than one year prior to the filing of the registration statement, if the required "90 day" balance sheet is not certified (paragraph 25), but provides no such authority with respect to interim balance sheets.2
If the Commission cannot conclude that it has the authority to require review of interim financial statements, the Commission could still encourage the national securities exchanges and Nasdaq to require a review of such interim financial statements and the Commission could require disclosure of whether the interim financial statements have been reviewed by an outside accountant.
Moreover, even if the Commission were not to adopt its proposal, we believe that the incidence of review of interim financial information of larger companies is relatively high. Many SEC registrants are required to provide the selected quarterly financial data specified by Item 302 of Regulation S-K in footnotes to their audited financial statements included in filings with the Commission. SAS 71, paragraphs .36 and .41 require auditors to modify their reports on those audited financial statements if they have not reviewed that financial data in accordance with SAS 71. In practice, such modified reports are rare. In addition, companies whose financial statements are audited by the "Big Five" accounting firms may be required to have their interim financial statements reviewed as a condition of the audit engagements.
However, any new requirement for review of interim financial statements will impose costs on reporting companies and, if adopted, should be applied, at least initially, to companies that can best support these costs. We have considered whether a requirement for review of interim financial statements should apply to smaller companies. On balance, the Committees recommend that, initially, only companies whose market capitalizations exceed $200 million, as suggested by the Blue Ribbon Committee, be subject to the requirement for review of their interim financial statements.3 These companies are likely to have the broadest following in the financial markets and should therefore be required to incur the additional expense necessary to provide greater reliability to the reporting of their financial results. Indeed, as discussed above, many of these companies already incur these costs.
The Committees recommend that, if the Commission adopts a requirement for review of interim financial statements that does not apply to smaller companies, it should revisit this issue after several years of experience with the efficacy of the review process and the actual cost to issuers to evaluate whether the threshold should be changed.4 The Committees also recommend that registrants whose interimfinancial statements have not been reviewed be required to include a statement to that effect in the table of contents or as an introductory caption to their interim financial statements.
Our Committees do not recommend requiring that these interim reviews be completed prior to public release of interim results. Some companies will recognize the problems that could result from releasing results to the public that may later be contradicted by information filed with the Commission, and will slow down or defer public release until the review is completed, despite the fact that the market is looking for prompt release of those results. However, those issuers that are sufficiently comfortable with their internal controls and accounting systems to make public release prior to completion of the auditors' review should be permitted to do so without first undergoing a review by their independent auditors, thus providing the securities markets with timely information.
The Committees believe that, if the Commission determines it has the authority to do so, it should apply the same requirements for auditors' review of interim financial statements to issuers filing registration statements under the Securities Act of 1933, as it applies under the 1934 Act. In fact, the Committees believe that practice is common today, even though not mandated, and is reflected in the "comfort letter" issued by accountants at the closing of a public offering. See Statement of Auditing Standards No. 72.
The Proposed Audit Committee Report
The Commission has proposed that a report of the audit committee be included in proxy statements relating to meetings at which directors are to be elected. (Proposed Items 306 of Regulations S-K and S-B.) The report would be required to state whether:
1. the audit committee has reviewed and discussed the audited financial statements in the company's latest Annual Report on Form 10-K or 10-KSB with management;
2. the audit committee has discussed with the independent auditors the matters required to be discussed by Statement on Auditing Standards No. 61 5;
3. the audit committee has received the written disclosures from the company's independent auditors required by the Independence Standards Board Standard No. 1 and has discussed with the independent auditors their independence; and
4. based on the review and discussions referred to in items 1 through 3 above, 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 included in the company's Annual Report on Form 10-K or Form 10-KSB for the year then ended contain an untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading.6
The Commission also proposes that the name of each member of the audit committee be printed below the report but that the members of the audit committee would not have to sign the report individually. Proposed Item 306(b).
The Committees have no serious objections to proposals 1, 2 and 3 above, or to applying those requirements to the board of directors if there is no audit committee. However, we have doubts about the utility of such reports, which, in practice, may result in boiler plate responses. An alternative that would avoid repetition of rote language encumbering proxy statements would be for the Commission to require disclosure if the actions covered by proposals 1 through 3 above were not taken.
The Committees are strongly opposed to proposed Item 306(a)(4). We believe that the proposed statement from audit committees would raise seriousliability concerns that would inhibit candid discussion among the audit committee, management and the independent auditors. These concerns range from clear exposure as litigation targets in the event of financial reporting complications or earnings disappointments and potential exposure to liability under Section 10(b) of the 1934 Act and Rule 10b-5, to possible liabilities under state law and sanctions under Rule 102(e) (see discussion under "Proposed Safe Harbors" below).
Moreover, we believe that this requirement could undermine the protection afforded by virtually all state corporate laws to directors who rely on the opinion of an independent accounting firm.7 By requiring audit committees to make representations to the public regarding the inquiries made by them, and the resulting "negative assurance", the Commission would be opening a breach in that wall of statutory protection which plaintiffs' lawyers will happily rush through.
We are troubled that the "negative assurance" that the audit committee would be required to provide in the proposed report would not enable its members to rely on the protections afforded by state law to directors who rely on reports of independent auditors, since the independent auditors would be reporting on the fair presentation of the financial statements and not providing the type of negative assurance required by the proposed audit committee reporting requirement.
Moreover, in light of Staff Accounting Bulletin No. 99, a heavy burden would be imposed on the audit committee to determine whether "anything" had come to its attention that would cause it to believe that the audited financial statements were materially misleading. This could have the affect of changing the role of the audit committee from one of oversight to that of an investigative body or a committee performing functions that more appropriately are those of management.
A meaningful liability "safe harbor" might alleviate, although not totally dispel, some of these concerns. However, as discussed below, the Commission's proposed safe harbors appear to us to be illusory. We believe that a safe harbor, suchas that provide for forward-looking statement in Sections 21E of the Exchange Act, would be preferable, if the Commission were to adopt proposed Item 306(a)(4).
For the same reason, the Committees would oppose requiring "more complete disclosure about the activities, processes and/or discussions of the audit committee, such as by requiring the committee to identify the significant accounting issues it considered and/or discussed. . . ." We believe such a requirement would be counterproductive and would chill free and open discussion among the audit committee, management and the independent auditors due to liability concerns. However, we would not be opposed to a requirement for the audit committee report to disclose whether the audit committee, or in the alternative the board of directors, had an opportunity to review and discuss the audit financial statements before those financial statements were included in the annual report filed with the Commission.
Proposed Safe Harbors
The Commission has indicated in Section III.E of the Proposing Release that they "do not intend to subject companies or their directors to increased exposure to liability under the federal securities laws, or to create new standards for directors to fulfill their duties under state corporation laws." In that connection, the Commission has proposed liability "safe harbors" for the new required disclosure. For the reasons discussed below, we do not believe that the liability safe harbors proposed by the Commission would be effective.
We believe the "safe harbors" proposed by the Commission are inadequate because:8
1. they do not address possible liability under Section 10 (b) of the 1934 Act and Rule 10b-5 thereunder;
2. they do not, and cannot, preempt state corporate laws providing for actions for breach of thefiduciary duty of care or the duty of candor in disclosure;
3. they do not, and cannot, preempt certain state securities laws;9
4. they do not address Commission administrative actions under
Section 21C of the Exchange Act or the degree of culpability the Commission must find to establish someone was a cause of a violation of Item 306 (a)(4); and
5. it is unclear whether a member of an audit committee who had been a certified public accountant would be subject to proceedings under SEC Rule 102(e).
1. Actions Under Section 10(b) of the 1934 Act and Rule 10b-5.
The "safe harbor" would not protect audit committee members against allegations that they violated Section 10(b) of the 1934 Act and Rule 10b-5 thereunder by acting "recklessly" in making the required statement. This creates an unacceptable degree of uncertainty, particularly since the Federal appellate courts have split on the issue as to whether some form of reckless conduct would support a finding of scienter and, if so, what conduct constitutes recklessness and how claims of recklessness should be plead forpurposes of Rule 10b-5 actions.10 Moreover, the Supreme Court so far has declined to address the issue.11
2. State Corporate Law. State corporate laws recognize causes of action for violation of the fiduciary duty of care, and violation of the duty of candor in disclosure by directors to stockholders and the public.12
While it is true that audit committee members may have substantial defenses to these claims, (including application of the "business judgment" rule, as noted in the Proposing Release), we are concerned that imaginative plaintiffs' counsel may be able to plead state law causes of action for misleading statements made pursuant to Item 306(a)(4) that may survive motions to dismiss, or for removal and dismissal under the Uniform Standards Act, resulting in expensive discovery practice and incentives to settle these actions to avoid the substantial expense of litigation.
3. State Blue Sky Laws. Section 28(f)(4) of the 1934 Act preserves the jurisdiction of state securities agencies to investigateand bring enforcement actions. The proposed safe harbor would not preclude such actions against audit committee members based on their report.
4. Cease-and-Desist Proceedings. Section 21C of the 1934 Act authorizes the Commission to enter cease-and-desist orders against any person who has violated or caused a violation due to an act or omission the person knew or should have known contributed to a violation. The Proposing Release is silent as to whether the liability safe harbor rules would protect against those proceedings. If the Commission is free to institute cease-and-desist proceedings against audit committee members who, it is alleged, "should have known" that their report would contribute to a in violation of the provisions of the 1934 Act, audit committee members will be exposed to substantial uncertainty, particularly uncertainty as to what state of mind is required to support such an allegation.13
5. Rule 102(e) Proceedings. The Commission has asserted the right to institute Rule 102(e) proceedings against financial officers who were, but no longer are, licensed CPAs, based on allegations of improper "professional conduct". See, e.g., Administrative Proceeding No. 3-9793, S.E.A.R. No. 41812 (August 31, 1999).
The New York Stock Exchange ("NYSE") and American Stock Exchange ("AMEX") and the National Association of Securities Dealers, Inc. ("NASD") have proposed that at least one member of the audit committee of a listed or quoted company must have had past employment experience in finance or accounting, requisite professional certification in accounting or other comparable experience. See Sec. Ex. Rel. Nos. 41980, 41981 and 41982 (October 6, 1999 ). Should these proposals be adopted, non-practicing CPAs might be discouraged from serving on audit committees of companies subject to those listing requirements, since the safe harbors would not protect them from possible Rule 102(e) proceedings.
Identification of Audit Committee Members.
Proposed Item 306(b) of Regulations S-K and S-B would require that the printed name of each member of the Company's audit committee (or the board of directors in the absence of an audit committee) must appear below the report required by Item 306(a) of those regulations.
The Commission's discussion of this requirement indicates that it is not its purpose to require individual signatures. However, the reference in accompanying footnote 59 to the Commission's brief amicus curiae in Howard v. Everex, may suggest to some that the Commission may be envisioning some form of liability of audit committee members akin to the liability it has asserted in its brief for signatories of 1934 Act reports. Moreover, since the members of the audit committee already are identified in the proxy statement and are likely signatories of the annual report, if requiring their names to appear below their report is not some form of additional "signature requirement," we question its purpose. Accordingly, the Committees oppose proposed Item 306(b), unless the Commission expressly provides that, in light of its stated purpose, the printing the names of the audit committee members immediately below their report, is not the equivalent of the audit committee members individually signing the report for liability purposes.
Other Disclosure in Proxy Statements About Audit Committees
The Commission proposes to add Item 7(e)(3) to Schedule 14A to require other disclosure about audit committees, their members and their charter.
The Committees have no objection to the proposed amendments to Item 7(e) of the proxy rules which would require disclosure of whether the audit committee has a written charter, and disclosure of certain information concerning audit committee members who do not satisfy the applicable independence standards of the NYSE, the AMEX or the NASD.
However, we believe that the requirement of including the audit committee charter as an appendix to the company's proxy statement is an unnecessarily costly way of providing this information to investors. If the Commission concludes that the audit committee charter should be considered a material corporate document, like the articles of incorporation and by-laws, it should require filing of a copy of the charter and any amendment thereto as an exhibit to the company's Annual Report on Form 10-K or Form 10-KSB and subsequent incorporation by reference in each succeeding filing of that report. The annual report requirement would be consistent with the proposals by the NYSE, the AMEX and the NASD that the board of directors review the audit committee charter annually. Interested persons could easily access the charter via EDGAR.
Application to Closed-End investment Companies
The Commission's proposal would apply to closed-end investment companies. As currently formulated, these proposals do not apply to open-end investment companies. We note that the Commission has recently proposed a series of rule changes addressing a variety of governance issues, including matters pertaining to the role of audit committees.
We believe that the accounting and auditing functions associated with the preparation of financial statements for investment companies are fundamentally different from those pertaining to most operating companies. Typically, these involve far fewer discretionary policies and judgmental issues. Their focus is primarily to assure that an investment company's net asset value is accurately calculated and reported. In this light, we question the need to impose these additional regulatory requirements on closed-end funds and would not favor any extension of these proposed rules to cover open-end funds.
In view of the unique governance structure mandated by the Investment Company Act, we recommend that any regulation of how the directors of an investment company conduct their affairs be implemented within the framework of the regulatory schemeestablished under the Investment Company Act. This is especially appropriate in view of the major rulemaking initiative currently under way with respect to investment company governance matters, including specific proposals pertaining to audit committees.Transition
In order for issuers to have ample time to revise their audit committee procedures in a thoughtful and deliberate manner, we believe that any proposals adopted by the Commission should be effective for filings relating to fiscal years beginning on or after December 15, 2000.* * * * *
The members of our Committees would be pleased to meet with members of the Staff or the Commission to discuss our concerns and the recommendations in our letter.
/s/ Stanley Keller
Stanley Keller, Chair
Committee on Federal Regulation of Securities
/s/ Richard H. Rowe
Richard H. Rowe, Chair
Committee on Law and Accounting
Barry Augenbraun, Coordinator
Dan L. Goldwasser
John F. Olson
Richard H. Rowe
Michael I. Young
cc: The Honorable Arthur Levitt, Chairman
The Honorable Paul R. Carey, Commissioner
The Honorable Isaac C. Hunt, Commissioner
The Honorable Norman S. Johnson, Commissioner
The Honorable Laura S. Unger, Commissioner
Harvey Goldschmidt, General Counsel
David B.H. Martin, Director Designate,
Division of Corporation Finance
Michael R. McAlevey, Deputy Director,
Division of Corporation Finance
1 We do not believe that the Commission has the authority to modify or supplement SAS No. 71. The Commission's only express authority to modify or supplement generally accepted auditing standards is found in Section 10A of the Exchange Act. That section applies only to audited financial statements and only to the matters specified in the section.
2 Paragraph (26) of Schedule A requires an interim profit and loss statement, "certified" by an independent public or certified accountant, if the registration statement is filed more than six months after the end of the registrant's fiscal year. The "review" service now provided by independent accountants did not exist at the time the 1933 and 1934 Acts were passed. See Statement on Standards for Accounting and Review Services No. 1 (A.I.C.P.A.,1978). Therefore, a review engagement cannot be the kind of "certification" referred to under the 1933 Act or the 1934 Act.
3 The Commission also should continue to consider the incidence of financial reporting problems experiences by smaller companies. See Fraudulent Financial Reporting 1987-1997, An Analysis of U.S. Public Companies, Research Sponsored by the Committee of Sponsoring Organizations of the Treadway Commission (March 1999). Given this report, some of our members would support applying the proposed requirement for review of interim financial statements to these smaller companies. However, a majority of the members believe that the costs would outweigh the benefits, at least at the outset.
4 Alternatively, the Commission could apply the criteria used in Item 302 of Regulation S-K for determining those companies that must provide selected quarterly financial data in their filings with the Commission.
5 As matter of drafting, we do not believe that the members of the audit committee would necessarily know what is required to be discussed by SAS 61. The proposal should refer to a discussion of the matters deemed by the auditors as appropriate to be communicated to the audit committee pursuant to SAS 61.
6 As a matter of drafting the reference should be to the Annual Report to shareholders pursuant to Rule 14a-3(b), as the Form 10-K report may not have been prepared at the time the proxy statement is mailed to shareholders.
7 See, e.g., Del. Code Ann tit. 8, Sec, 141(e) (1998); Cal. Corp. Code Sec. 309 (b) (2) 1998; Ill. Comp. Stat. Ann. Sec. 5/8.65(c) (1998); N.Y. Bus. Corp. Law Sec. 717 (a)(2) (1997); Letter dated September 27, 1999 from Dan L. Goldwasser to Robert E. Burns, Counsel to the Office of Chief Accountant, Securities and Exchange Commission, enclosing a schedule of the relevant state laws. We also note that Section 11 of the 1933 Act protects directors who rely on experts, including independent auditors, from liability under that section.
8 We note that if a "negative assurance" or similar "certification" requirement is not adopted, the issue of a liability safe harbor would become less of a concern. As noted above, should a liability safe harbor be necessary, we believe one similar to the safe harbor for forward-looking statements provided by Section 21E of the Exchange Act would be preferable.
9 Section 28(f)(4) of the Exchange Act preserves the authority of state securities authorities to bring actions under state Blue Sky laws.
10 See, e.g., Donald Press, et al. v. Chemical Investment Services Corp., et al., 166 F3d 529 (2nd Cir. 1999);Sunstrand v. Sun Chem. Corp. (7th Cir. 1977); Williams v. WMX Technologies Inc., 112 F.3d 175, 177-78 (5th Cir. 1977); Press v. Chemical Inv. Servs. Corp., 166 F.3d 529 (2d. Cir. 1999); In re Advanta Corp. Sec. Littig., 180 F.3d 525, 534 (3d Cir. 1999); In re Silicon Graphics Inc. Sec. Littig., 183 F.3d 970, rehearing denied (October 27, 1999) (9th Cir. 1999) ("deliberate recklessness"); In re Comshare Inc. Sec. Littig., 183 F.3d 542 (6th Cir. 1999); Bryant v. Avado Brands Inc., No. 98-9253, ___F.3d___, 1999 WL 688050, [Current] Fed. Sec. L. Rep. (C.C.H.) ¶ 90,636 (11th Cir. September 3, 1999) ("severe recklessness"); Phillips v. LCI International Inc., No. 98-2752, ___F.3d ____, 1999 WL 717 253, [Current] Fed. Sec. L. Rep. (C.C.H.) ¶ 90,645 (4th Cir. September 15, 1999); Greebel v. FTP Software Inc., No. 98-2194 [Current] Fed. Sec. L. Rep. (C.C.H.) ¶ 90, 658 (1st Cir. October 8, 1999) (definition of scienter includes recklessness, "closer to being a lesser form of intent")
11 Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).
12 See, e.g., Emerald Partners v. Berlin, 726 A.2d 1215 (Del. 1998); Malone v. Brincat, 722 A.2d 5 (Del. 1998); Lewis v. Vogenstein, 699 A.2d 327 (Del.Ch. 1997); Arnold v. Society for Savings Bancorp, Inc., 650 A.2d 1270 (Del. 1994); Lynch v. Vickers Energy Corp., 383 A.2D 278, 279 (Del. 1978).
13 Cf. Checkosky v. SEC, 139 F.2d 221 (D.C. Cir. 1998).