November 24, 1999
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
E-mail address: email@example.com
Re: File No. S7-22-99: Audit Committee Disclosure
Dear Mr. Katz:
On behalf of the American Corporate Counsel Association ("ACCA"), we are responding to the request made in Release No. 34-41987 (the "Release") for comments on the Commission's proposals relating to audit committee disclosures. We also briefly comment on the proposed rule of The New York Stock Exchange relating to the financial literacy and experience of audit committee members, which is addressed in Release No. 34-41980.
ACCA is the only national bar association exclusively for in-house corporate counsel. With more than 11,000 individual members who act as in-house counsel to more than 4,400 business entities, ACCA is uniquely positioned to comment on issues closest to the legal agenda of America's corporate sector. ACCA's Corporate and Securities Law Committee has more than 2,800 attorney members (most of whom work in public companies), and was formed in part to help ACCA members share opinions on issues of particular interest within their practice. Thus, the undersigned feel that our comments provide the Commission with a perspective that is particularly qualified regarding the issues raised in Releases 34-41987 and 34-41980.
We support your efforts to enhance the reliability and credibility of financial statements of public companies, and agree that the audit committee is well positioned to help facilitate this objective. However, we have concerns relating to several of the proposals which we believe would unduly increase the legal liability and reputational exposure of audit committee members and very possibly discourage qualified candidates from serving on the boards of directors of public companies, without producing any corresponding benefits to the reliability and credibility of financial statements.
The Audit Committee Report
Proposed Item 306 (a) of Regulation S-K would require that an audit committee provide a report in a company's proxy statement, stating whether:
(1) the audit committee has reviewed and discussed the audited financial statements with management
(2) the audit committee has discussed with the independent auditors the matters required by SAS 61
(3) the audit committee has received the written disclosures and the letter from the company's independent accountants required by Independence Standards Board Standard No. 1, and has discussed with the independent accountants their independence and
(4) based on the review and discussions referred to in paragraphs (1) through (3), 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 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.
We believe paragraph (a)(4) of Item 306 is not advisable for several reasons. First, we believe the requirement (1) improperly transforms the oversight role of audit committee members with respect to a company's financial statements to an audit role, and (2) fails to recognize the practical constraints inherent in the involvement of directors in a company's affairs. 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 also be entitled to rely upon management and the outside auditors with respect to the accuracy of the financial statements and compliance with applicable rules, including the disclosure obligation set forth in paragraph (a)(4). Our rationale is that management and the outside auditors are much better positioned from a time and resource perspective to perform the necessary diligence to be knowledgeable about the intricacies of a company's financial reports. This is consistent with state corporation law, which generally permits reliance by board members on outside experts and corporate personnel.
The wording of paragraph (a)(4), read literally, acknowledges reliance by the audit committee on management and the outside auditors in making the judgment called for by paragraph (a)(4). However, the reality is that requiring the audit committee to give negative assurances about the accuracy of the financial statements will increase investor expectations of audit committee involvement and will compel the members of the committee to delve much deeper into the financial analysis than an oversight and monitoring function should mandate. This, in turn, will inappropriately shift a significant portion of the traditional function of management and the outside auditor to the audit committee-and very possibly result in a distorted perception by shareholders of the audit committee's role in a company's financial process. We agree that the audit committee is, and should continue to be, a key link between management and the outside auditors in monitoring the financial reporting process, but the disclosure in paragraph (a)(4), and the conduct it is likely to engender, goes well beyond that role.
The disclosure requirement in paragraph (a)(4) may also create unjustified costs and be inconsistent with the paramount goal of fair financial reporting. In carrying out their new responsibilities under paragraph (a)(4), we believe many audit committees will feel the need to retain separate auditing firms and law firms to provide comfort; that such firms will need ongoing involvement in company affairs on a regular basis to provide the audit committee such comfort; and that such involvement by these firms will significantly increase costs to public companies without any measurable benefit. Further, we believe the audit committee's new role might cause the audit committee and its own law and audit firms, on the one hand, and management and the "regular" outside auditors, on the other hand, to fall out of alignment, shifting from a common goal of fair financial reporting to a personal interest in minimizing liability.
Finally, we believe a likely result of the paragraph (a)(4) obligation is that audit committee members will become targets of litigation more frequently, and because of this threat, qualified director candidates will be deterred from serving on the boards of public companies. In this respect, the proposed (a)(4) requirement could very well lead to a deterioration, rather than improvement, in the quality of audit committee involvement in a company's financial process.
Although we would prefer to see paragraph (a)(4) deleted from Item 306 for the reasons discussed above, if some disclosure requirement is deemed necessary by the Commission, we would be more inclined to support the alternative discussed in the Release that the audit committee disclose whether, based on the discussions disclosed in paragraphs (a)(1)-(a)(3), they recommended to the full board that the audited financial statements be included in a company's 10-K. We believe this requirement would be consistent with the audit committee's responsibility to oversee the financial reporting process, and present less litigation exposure to audit committee members than the current proposal. We believe requiring audit committees to go further than this statement and disclose whether they know of any material modifications that should be made to the financial statements, as described in the Release, would be inappropriate and counterproductive for the same reasons mentioned above in connection with an audit committee's negative assurances relating to material misstatements or omissions in the financial statements.
We do not believe that the disclosure requirement in paragraph (a)(4) would appropriately reinforce the audit committee's awareness and acceptance of their responsibility because, as discussed above, we believe the requirement in (a)(4) misconceives the proper role of the audit committee. The disclosure requirements of paragraphs (a)(1)- (a)(3) will make the role of the audit committee more visible to investors in promoting reliable and transparent financial reporting, and we believe paragraph (a)(4) is unnecessary to accomplish this objective. We also do not believe the Commission should go beyond paragraphs (a)(1)-(a)(3) and require more complete disclosure about activities, processes and discussions of the audit committee. Any such required disclosures may very well inhibit frank discussions between the audit committee, management and the outside auditors. Such discussions are critical to fair financial reporting. Further, we fear such disclosures might subject these discussions to a whole new rash of potential litigation.
The Audit Committee Charter
Proposed Item 7(e)(3) of Schedule 14A would require companies to disclose in their proxy statement whether their audit committee is governed by a charter, and if so, to include a copy of the charter as an appendix to the proxy statement at least once every three years. The Release states this requirement would help shareholders assess the role and responsibilities of the audit committee and help focus committee members on their responsibilities.
We do not believe including the charter in an appendix to the proxy is necessary to achieve these objectives. Disclosing whether a company has an audit committee charter, and describing key aspects of the audit committee as required by current Item 7(e) of Schedule 14A, will provide sufficient information to shareholders about the operation of an audit committee and adequately focus audit committee members on their responsibilities. Attaching the charter to the proxy statement is likely to provide fodder for litigious plaintiffs without significant corresponding benefits. In fact, the development of boilerplate charters to better position companies against such litigation is a likely and undesirable result. Requiring audit committees to disclose whether they have complied with their charter will only exacerbate the litigation threat. A better approach may be to have the outside auditor be charged by companies with the responsibility of reporting audit committee charter compliance to a company's board each year without involving public disclosures that may expand shareholder litigation.
The Commission has proposed a safeharbor for the new disclosures under Item 306 of Regulation S-K and Item 7(e)(3)(v) of Schedule 14A which would track the safeharbor for compensation committee reports currently provided by Item 402 of Regulation S-K. As such, the disclosures would not be considered soliciting material filed with the Commission subject to Regulation 14A or 14C or to the liabilities of Section 18 of the Exchange Act. In proposing the safeharbors, the Release states the Commission does not intend for the new disclosure rules to subject companies or their directors to increased exposure to liability under the federal securities laws or to create new fiduciary standards for directors under state corporation law.
We believe that the audit committee disclosure requirements under Item 306 of Regulation S-K and Item 7(e)(3) of Schedule 14A will subject the audit committee to increased legal exposure, and that a safeharbor should be adopted that covers all of the disclosures required by such provisions. We believe the safeharbor should apply even to those disclosures that are factual because the language in those provisions can be subject to interpretation, and the safeharbor will cut off much of the potential vexatious litigation that could arise challenging compliance with such provisions.
In terms of its scope, we are concerned that the proposed safeharbor will only be of limited benefit. First, it will not protect issuers and directors from liability under the antifraud provisions of the federal securities laws and SEC administrative sanctions. To address this concern, the safeharbor 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 are also concerned that the proposed safeharbor would not protect issuers and directors from suits that may arise under state law, which could also be a serious deterrent to qualified candidates considering service on corporate audit committees. To address this exposure, the Commission should consider making violations of the proposed rules subject only to Commission enforcement actions, and not private actions.
We believe there should be a significant transition period if Rule 306 and Item 7(e)(3), or portions thereof, are adopted by the Commission, and that such rules should not be effective in 2000, unless existing audit committees are exempted. Issuers should have a fair opportunity to consider the implications of these rules and revise their audit committee procedures prior to the obligation to make new disclosures about the functioning of the audit committee. This will provide companies the time to give careful thought and consideration to potential improvements to their audit committee processes, which in turn will redound to the benefit of shareholders. In addition, the adoption of the proposed rules could prompt widespread resignation of audit committee members, and companies would require time to recruit and educate their replacements.
Financial Literacy and Expertise
The New York Stock Exchange has proposed Rule 303.01(B)(2), applicable to its listed companies, that would require each member of an audit committee to be "financially literate," and to have at least one member of the audit committee with "accounting or related financial management expertise." Such qualifications would be subject to interpretation by a board of directors in its business judgment. The Commission has sought comments on this proposed rule in Release No. 34-41980 (File No. SR-NYSE-99-39). Although we understand the benefit of having financially savvy members on a board of directors, we believe that the standards for "financial literacy" and "accounting or financial management expertise," even if within the judgment of the board, may be difficult to define and possibly defend, if the qualifications of audit committee members are challenged by litigious plaintiffs.
Imposing these requirements on audit committee members may also limit the talent pool available to corporate boards. Many candidates that meet these standards may not have the well rounded skills important to the broader duties of directors generally. Even with respect to audit committee responsibilities, broad skills are necessary to fulfill oversight roles relating to areas such as controls, operations, risk management, compliance and regulatory relations, among others. We also believe qualified board candidates with all of the requisite financial and other skills may not want to serve on audit committees because of the disproportionate amount of time they will need to spend on financial matters to justify their selection, or out of fear that as audit committee members, they will be held to a higher standard of care than other directors.
As a practical matter, the proposed rule would create two classes of directors-those who can serve on the audit committee and those who cannot. This would prevent rotation by board members among all board committees, which would clearly detract from the ability of directors to develop the broad committee experience and knowledge about a company that over time can significantly contribute to the overall effectiveness of a board.
* * *
|John H. McGuckin, Jr.||Richard M. Starr|
|Chairman of the Policy Committee||Chairman of the Corporate and Securities|
|American Corporate Counsel Association||Law Committee|
|Exec. VP, General Counsel & Secretary,||American Corporate Counsel Association|
|Union Bank of California||Managing Counsel, American Express|
cc: The Honorable Arthur Levitt, Chairman
The Honorable Norman Johnson, Commissioner
The Honorable Isaac C. Hunt, Jr., Commissioner
The Honorable Paul R. Carey, Commissioner
The Honorable Laura S. Unger, Commissioner
The New York Stock Exchange, Inc.
Maud Mater, General Counsel, Freddie Mac, Board Chair, American Corporate
Michael Roster, General Counsel, Stanford University, Vice Chair, American
Corporate Counsel Association
Frederick J. Krebs, President, American Corporate Counsel Association