November 29, 1999
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Securities Exchange Act Release No. 34-41987
(File No. S7-22-99)
Dear Mr. Katz:
FirstEnergy Corp. (FirstEnergy) welcomes the opportunity to comment and to express its concerns regarding the proposed rulemaking by the Securities and Exchange Commission (Commission). FirstEnergy is a diversified energy services holding company with more than $18 billion in assets and nearly $6 billion in annual revenues. FirstEnergy's electric utility operating companies - Ohio Edison Company, Pennsylvania Power Company, The Illuminating Company and Toledo Edison Company - comprise the nation's 10th largest electric system, serving 2.2 million electric customers in Ohio and Pennsylvania. Through its FirstEnergy Services subsidiary, FirstEnergy also serves commercial and industrial customers in New Jersey and Delaware.
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. On the whole, we support the proposals contained in Release No. 34-41987 (Release) and the recommendations of the Blue Ribbon Committee. We are concerned, however, that a number of the proposals do not adequately address a recognized risk - that is, 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. This disclosure would state whether the audit committee has (a) reviewed and discussed the audited financial statements with management and (b) discussed certain matters with the independent accountants. The proposal would also require the audit committee report to state whether anything came to its attention that caused it to believe that the audited financial statements contained an untrue statement of material fact or omitted a material fact necessary to make the financial statements not misleading. In general, we do not favor the issuance of an audit committee report in the proxy statement for the following reasons:
FirstEnergy's audit committee employs an external independent accountant to review and render an opinion on the accuracy and completeness of the company's financial statements.
The audit committee recognizes that the external independent accountant is subject to compliance with generally accepted auditing standards and periodic peer reviews to ensure the quality of their work.
We do not believe that additional opinions by the audit committee would serve any benefit to the shareholders.
The audit committee discusses the "independence" disclosures required by the external independent accountant annually as part of their review of the accountant's work.
Discussions held by an audit committee with its independent accountant should be considered proprietary and disclosure of subjects discussed could prove harmful to a company. These discussions may involve potential impacts of events which have not yet been finalized or reveal significant underlying support for specific expectations reflected in the financial statements for which public disclosure could prove harmful to a company if related to subjects under negotiation with third parties.
Discussions with management should also be considered proprietary and disclosure of the topics and conclusions reached could expose a company to potential compromises of its market position or negotiating positions.
The fact that the audit committee would disclose the topics of discussion could raise questions in the mind of the shareholder concerning why such discussions were held. Further, it could create uncertainty in the mind of the shareholder that disclosures in the financial statements might be misleading or incomplete when in fact they were not.
Audit committee members do not believe they are in a more knowledgeable position than an independent accountant employed by the shareholders to perform evaluations of the financial statements. The "negative assurance" (i.e., statement that nothing came to their attention) would imply that the audit committee would be in a position to "second guess" the independent accountant regarding the accuracy of their reviews and the conclusions reached on items not discussed with the committee. The potential liability from such statements would expose audit committee members to increased risk with no substantial benefit to the shareholders.
Audit committees believe it is their obligation to oversee the audit process and ensure that a qualified independent accountant is recommended and that the results of their work has been properly handled by management. We believe audit committees see their roles as one of oversight, not duplication.
In addition, the proposed paragraph (a)(4) of the rule would require the audit committee to characterize the company's financial statements and state whether "anything" came to its attention that 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 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.
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.
Additionally, we disagree that the audit committee disclosure should appear over the printed names of the audit committee members. Committee memberships are disclosed elsewhere in the proxy statement. This additional proposed requirement is duplication and neither adds to the fiduciary responsibility of the audit committee nor does it emphasize to shareholders a greater importance of the audit committee's role. Also, all committees of the board of directors have important fiduciary responsibilities, and treating a single committee differently by requiring printed names is inappropriate.
As an alternative to the proposal, the same effect could be achieved by merely supplementing Item 7(e) of Schedule 14A to disclose more generally whether (1) the audit committee has met with management and the independent auditors to discuss significant accounting issues that developed in preparing the financial statements; and (2) the audit committee is governed by a charter.
The Safe Harbor
Should the Commission adopt the proposed rule to require an audit committee report, we request further clarification of this matter as it relates to the proposed safe harbors. In order to more effectively protect the audit committee members from unnecessary exposure to liability, we believe the safe harbor provision 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 the statement as to their beliefs was reckless.
To remedy these concerns, we recommend the Commission provide a safe harbor equivalent to that provided for "forward-looking statements" in the Private Securities Litigation Reform Act of 1995, which raises the degree of knowledge component for legal responsibility beyond recklessness to actual knowledge of fraud. We believe 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.
Review of Quarterly Financial Statements
We concur in the proposed amendments to Rule 10-01(d) of Regulation S-X and Item 310(b) of Regulation S-B to require a company's interim financial statements be reviewed by an independent public accountant prior to the company filing its Form 10-Q or 10-QSB with the Commission. We do not believe it would be appropriate, however, to require interim reviews be completed prior to quarterly earnings releases when these releases are made prior to the filings with the Commission. Although some companies may elect to have such a review, this requirement could be counterproductive and result in the delay of the release of earnings reports and market sensitive information, which normally is released as promptly as practicable after availability.
However, we do not favor the requirement proposed by the Blue Ribbon Committee that audit committees discuss with the independent accountant the matters covered in SAS 61 prior to the filing of the quarterly Form 10-Q. We believe that the timing of such reviews, as well as the incremental costs, would be contrary to the current audit committee's meeting schedule and would require more meetings of the committee and increased meetings with the independent accountant with no perceived value.
Under no circumstances do we believe the Commission should shorten the filing deadline for Form 10-Q. In addition, we do not believe the Commission should require a report on the independent auditor's review be mandatorily filed.
Should the Commission adopt the proposed rule to require an independent accountant review of interim financial statements, we request clarification as to the acceptable mode of communication with the audit committee members and requirements as to the extent of approval by the audit committee, which will satisfy this requirement.
Audit Committee Charter
Audit committee charters are effective tools to clarify the audit committee's responsibilities and are presently utilized by most companies. However, we do not believe it is necessary to disclose whether the committee has complied with the charter, as this should be assumed. Instead, disclosure should be required if there are any material deviations by the audit committee from its charter obligations.
With respect to including a copy of the charter in the proxy statement at least once every three years, we question the need for such a requirement. We do not believe that shareholders have a great interest in the details of a charter and feel they are more interested in generally knowing that the audit committee is performing its fiduciary responsibilities. We do not favor the exposure or filing of our audit committee's Charter with the SEC nor any statement in the financial statements concerning the content or compliance with the Charter by the audit committee. FirstEnergy's position is based on the following:
The audit committee Charter is unique for each company and thus may or may not contain useful information for the shareholder.
A generalized statement of the role of the audit committee already exists in the financial statements. We believe that such a statement provides the reader of the financial statements sufficient information concerning the major scope of the audit committee.
The Board of Directors (Board) uses a more detailed charter to ensure specific tasks have been assigned to particular committees to avoid duplication or omission of responsibilities. Thus it is a tool used to confer responsibility and authority.
The duties and responsibilities of an audit committee may vary among companies based on the desires of the Board. Thus disclosure of the charter may result in efforts to ensure consistency among companies which could restrict the Board's ability to make decisions on what tasks are best performed by which committee of the Board.
The added cost of printing the charter in the proxy statement and increasing the mailing weight could be significant for a company like FirstEnergy with over 300,000 shareholders.
Should the Commission adopt the proposed rule to include a copy of the charter in a company's proxy statement at least once every three years, we believe that it would be more cost effective and efficient to require the charter to be filed each year as an exhibit to the Annual Report on Form 10-K. Furthermore, the Form 10-K relates more closely to the financial statements, which are usually issued prior to the proxy statement being issued and are publicly available on EDGAR. We do not perceive a need to single out the audit committee charter for inclusion in the proxy statement when other documents of equivalent or greater significance need only be included in a company's periodic reports under the Exchange Act. The proxy statement could be required to include a statement to the effect that the charter is filed as an exhibit to the Form 10-K and copies of the charter may be obtained without charge upon written request to the company.
Disclosures About "Independence" of Audit Committee Members
We concur with the Commission's view that shareholders should know when a member of an audit committee is not independent. Therefore, disclosure should be made in the company's annual proxy of the absence of independence.
We appreciate the opportunity to share our concerns regarding the Proposal. We hope that the Commission weighs our concerns together with those of other respondents in arriving at a final rulemaking.
Harvey L. Wagner