Timing of Disclosure. The financial expert disclosure should not be required for mid cap and small cap issuers until at least one year following promulgation of the rule in order to allow an opportunity to assess the impact of "financial expert" disclosures and address appropriately investor reaction to companies that either report that they have no financial expert or no "independent" financial expert on the audit committee.
I. An Independence Definition That Recognizes The Value Of Large Shareholders Directors On Audit Committees Is Critical To The Continuation Of A Sound Trend In Corporate Governance.
Boards of venture-backed IPO companies frequently request that directors who represent venture capital funds remain on the board following the IPO and serve on the audit committee. Representatives of venture capital funds with large ownership stakes are often the best directors for audit committee service because they are financially sophisticated, independent from management, and well informed about the company and its financial condition. As a fiduciary to investors in a fund that holds a large stake in the issuer, the venture capital (VC) director, in turn, is a highly effective fiduciary to all other shareholders.
There is increasing empirical verification of the general view that persons with significant shareholdings often make the best directors. An important academic study shows that directors with a meaningful stake are a pivotal governance factor in improved corporate performance.2 For some time, experts have argued that significant director shareholdings are the most effective way to get outside directors to vigorously represent the firm's shareholders.3 In "Outside Directors With a Stake: The Linchpin In Improving Governance," supra note 2, Donald C. Hambrick and Eric M. Jackson, empirically examine the impact of outside director share ownership in both well performing and poorly performing companies. Their results showed a strong correlation between the significance of outside directors' share ownership and company performance.4
Similarly, a study by Sanjai Bhagat, Dennis C. Carey and Charles M. Elson, "Director Ownership, Corporate Performance, and Management Turnover," 54 Bus. Law. 885 (1999), confirms that effective agency is created by directors that are substantial shareholders and the correlation between large shareholder directors and effective board oversight. The study emphasizes the importance of "ownership and control through meaningful director stock ownership and hence better management monitoring." 5
Therefore, the value of large shareholders as directors has been repeatedly demonstrated.6 Certainly the latest evidence shows that the presence of directors with large shareholdings correlates strongly with corporate performance and shareholder value - key issues for any public company board. VC directors clearly offer this advantage to publicly traded companies both as directors and as audit committee members. They combine the familiarity with the issuer and its business that most outside directors lack with the independence from management that the Sarbanes-Oxley Act is intended to promote.7
The requirement to disclose the independence of a financial expert under this proposed rule can seriously inhibit this sound trend in governance if an overly restrictive disqualification based on share ownership is imposed.
II. Response to Questions Regarding Disclosure of "Independence".
a. "Independence" disclosure should be postponed and addressed in a separate rulemaking.
The Commission should not require disclosure regarding independence as part of financial expert disclosure at this time. As noted in the release accompanying the proposed rule (Release), such disclosure is not required by the Act and all major exchanges have either proposed or required that all audit committee members be independent. Furthermore, Exchange Act Section 10A(m)(1) appears to require that, not later than April 26, 2003, any company whose audit committee does not meet the Section 10A(m)(3) definition of "independent" will face delisting. Therefore, disclosure regarding independence of a financial expert on the audit committee will be redundant for thousands of companies listed on national securities exchanges. For the Commission to add a new disclosure requirement that is not mandated by the Sarbanes-Oxley Act will impose unnecessary burden and add to the confusion caused by the myriad mandatory new Sarbanes-Oxley Act requirements. Moreover, unless addressed artfully this new disclosure will create counterproductive new restrictions on audit committee service by directors who are heavily invested in the issuer and are clearly independent of management.
Therefore, it is NVCA's view that the meaning of "independence" under new Section 10A(m)(3) presents sufficient problems that it should be the subject of separate rulemaking, notice and comment, rather than be left for each company to interpret the term as drafted into the Act.
b. If the Commission requires "independence" disclosure at this time, issuers should use existing listing standard definitions of independence rather than the new Section 10A(m)(3)(B) independence criterion.
If disclosures regarding the independence of financial experts on the audit committee are to be required at this time, then the term "independence" should be defined with reference to the exchange listing standard definitions, not the Sarbanes-Oxley Act. The exchanges have had audit committee independence rules in place for a number of years. These standards can be applied immediately without the need to separately interpret new Section 10A(m)(3). Moreover, a literal reading of Section 10A(m)(3) will cause many high quality, highly independent VC directors to suddenly fail to qualify as independent because they represent funds that own more than 5% of the issuer. The same rule will disqualify other highly qualified directors, including some of America's most respected investors. Such a result would run contrary to basic principles of good corporate governance and the proven correlation between directors with a stake in the company and strong corporate performance.
Removal of such directors would, therefore, run contrary to one of the main purposes of the Sarbanes-Oxley Act. In the governance arena, the Act intends to address the problem of directors whose ties to management compromised their oversight function. Clearly, situations where directors are beholden to management raise independence concerns. When the audit committee has members who are significant shareholders, it is extremely difficult for such a situation to arise. Any director whose own financial stake is aligned with other shareholders will have no motive to accommodate questionable accounting by management. Rather, investors with a real investment stake are motivated to bring exacting oversight to management's preparation and the auditor's review of financial statements.
The exchanges have reviewed the relationship of large shareholders to audit committee independence and their rules reflect an appropriate respect for the value that these types of directors add to boards and audit committees. Exchange definitions and rules regarding level of ownership that might raise "affiliate" or "independence" issues are based on the years of experience and a number of separate opportunities to analyze the issue. For this reason alone, these definitions provide a better basis for disclosure of the independence of a financial expert. Moreover, these rules clearly distinguish the management insider or consultant on the audit committee from the typical large shareholder director, while the (3)(B) definition would lump all such directors together.
Another reason to use the current exchange guidance is to give the Commission and the exchanges time to develop a means of applying (3)(B) with the requisite clarity envisioned in the Sarbanes-Oxley Act. Section 10A(1)(B) requires that that SROs "provide for appropriate procedures for an issuer to have an opportunity to cure any defects" in its compliance with paragraphs (2)-(6). Such "appropriate procedures" surely involve a full explanation of how paragraphs (2)-(6), including the independence definition in (3) will be applied before any company faces the draconian punishment of delisting. To date, while the exchanges recognize that the Sarbanes-Oxley Act Section 301 may run contrary to their own conclusions regarding audit committee service by large shareholder directors,8 there is only uncertainty as to which rule will apply.
If issuers are required to disclose whether a financial expert meets the requirements of subsection (3)(B) each one will need to individually interpret the meaning of "affiliated person of the issuer or any subsidiary thereof." The Act's use of the term "affiliated person" imports, perhaps unintentionally, Investment Company Act (ICA) terminology and restrictions into the definition of independence for audit committee purposes.9 Whether or not it should be interpreted as doing so should be addressed separately through a rulemaking, under Section 10A(m), which expressly grants the Commission authority to exempt "a particular relationship" from the requirements of subparagraph (B).
For the reason noted above, the "particular relationship" of large shareholder, or at least the relationship of representative of a large shareholder fund, should not be denied independent status or excluded from audit committee service based on the "affiliated person" test that would be imported by this rule from the ICA.
c. If the Commission determines that the (3)(B) independence criteria mush be used, it should advise issuers to interpret the term, "affiliated person," in (3)(B)(ii) in the same manner as the term "affiliate" is interpreted under Exchange Act Rule 12b-2.
Nearly every Exchange Act determination on the regulatory consequence of an affiliation is dealt with under Rule 12b-2, not Section 3(b)(19) of the Exchange Act. It would be wholly appropriate, where possible, to use well-known Exchange Act rules to implement Section 10A(m).
Indeed, the Commission should consider supporting a technical amendment to Section 301 of the Sarbanes-Oxley Act to change "affiliated person" in subparagraph (B) to "affiliate" and return the analysis of audit committee independence to the more appropriate context of Exchange Act Rule 12b-2.10 SROs have developed their current rules dealing with affiliation for audit committee independence using an analysis based on Rule 12b-2. Therefore, a sound argument can be made that the Act's use of the term "affiliated person," was either a legislative counsel drafting error, or was based on the understandable mistake of assuming that "affiliate" and "affiliated person" would have the same familiar meaning in the Exchange Act context.
By whatever means, the literal effect of (3)(B) should be avoided in order to promote the larger goals of the Sarbanes-Oxley Act.
III. Response to Questions Regarding "Financial Expert".
a. The Commission should allow the maximum flexibility available under the Act in defining "financial expert".
The Commission should allow the maximum flexibility available under the Act in defining "financial expert" so that issuers will not feel compelled to replace highly qualified and financially expert directors for failure to meet some overly narrow criteria in the definition of "financial expert." While some VC directors will qualify as financial experts under the narrow terms added by the Commission's rule proposal, the rule proposal contains a provision that will create uncertainty in making the disclosure as to financial expertise.
NVCA urges the Commission to make it clear that boards are the ultimate arbiters of whether someone is a financial expert for their audit committee. We take some comfort in the Release language that "[s]ome individuals who are particularly knowledgeable or experienced in accounting and financial issues may have the requisite attributes and mix of knowledge and experience to qualify as financial experts, even though they may not have served in one of the specifically identified positions."11 With proper emphasis of this aspect on the rule, many VC directors could be qualified by a board as a financial expert.
However, the specificity of the factors that the proposed rule requires the board to consider in comparing a persons' knowledge and experience could also lead to the conclusion that only very particular types of experience will qualify. The most troubling of these required factors are adopted directly from the Act:
1) Experience applying GAAP "in connection with the accounting for estimates, accruals, and reserves that are generally comparable to" those in the registrant's financial statements.
2) Experience preparing or auditing generally comparable financial statements.
These two required factors, coupled with the Commission's proposed requirement that such experience "be related to companies that were, at the time ... public reporting companies," can be read to restrict the universe of experts to those who were chief financial officers, controllers, or auditors of publicly traded companies. Such a strict adaptation of the Section 407 requirement would disqualify many seasoned and experienced VC directors who have served effectively on dozens of audit committees.
Venture capitalists come from a wide variety of educational backgrounds and professional experiences - accounting, legal, scientific, management, engineering, finance, etc. The common characteristic of any successful VC is the ability to understand the financial fundamentals of a given company. Inherent in this ability is the ability to read financial statements, assess the quality of financial information, and test the validity of outside audits. These are the skills that audit committees need. And application of those skills in myriad situations is the experience that an audit committee financial expert needs.
An effective way to encourage companies to include financial experts on audit committees would be to interpret the Section 407 disclosure requirement in the overall context of the Sarbanes-Oxley Act. Of course, the Commission has more discretion than it has taken since it is required only to "consider" the four criteria set out in Sec 407(b), not to write them into the rule. Given that the Act provides this flexibility, the Commission should evaluate whether strictly adhering to the criteria specified above is consistent with the mandatory provision in Section 301, which specifies that audit committees will have the authority to retain outside advisors, as they deem necessary.
It should not matter to investors whether the audit committee is fulfilling its responsibilities with the assistance of a committee member who has extensive specialized experience in financial reporting and accounting or is doing so with the assistance of outside experts. Investors will view disclosure that there is, or is not, a financial expert on the audit committee the same way audit committee members will. An audit committee member, preferably the chairman, who has experience in accounting, auditing, or financial reporting, serves the role of committee peer to whom other members can voice concerns on matters relating to the more technical aspects of financial accounting. The value of a financial expert on the committee is to be the person who knows when outside technical expertise is needed - not to be the committee's technical expert. However, under the proposed rule, some issuers whose audit committee members have exceptional financial expertise will need to inform shareholders that they do not have a "financial expert," because their members lack the specific criteria set forth in the proposed rule. They will then, perhaps, go on to explain that the committee has such expertise available to it from outside the company - a fact most investors would assume without any disclosure.
An overly restrictive rule governing financial expert obligations and disclosures will have one of two unfortunate results. The vast majority of companies will render negative reports and offer similar explanation as to the lack of an expert. Such a response is reinforced by at least the perception of additional liability exposure for the designated expert. See, text accompanying footnote 11, infra. Furthermore, if there is no financial expert, there will be no disclosure as to the independence of the audit committee members best qualified to fill that role.
Another possible result will be that institutional shareholders and their voting advisors will decide that some form of punishment is appropriate for companies that, regardless of size, do not have an independent financial expert. In this case, the Commission's definition, which is thought to be "disclosure-only" and of little consequence to most smaller issuers, would create a significant imbalance in the demand for rule-compliant financial experts and the supply of those who are both "financial experts" and qualified board members.
Whatever rule the Commission promulgates should avoid either of these two unconstructive potential consequences. Instead, any forthcoming rule should utilize the flexibility that the statute confers and include a definition that recognizes that audit committees may need a different kind of financial experience than that which is gained either at operating companies or audit firms. Such a rule should accommodate the impact on smaller issuers rather than simply assuming that it will be minimal.
More good, and less harm will come from establishing criteria that experienced audit committee members - as opposed to current or former financial executives - will meet. Financial expert criteria should, to the extent that the Act permits, emphasize qualities and experience of seasoned audit committee members rather than formal training or narrow experience in financial or accounting roles. Audit committees can hire accounting and auditing experts and exchange rules will soon require that audit committees have such expertise available on demand. To the maximum extent possible the Commission should turn the rule in this direction by interpreting the Act more broadly and using the flexibility provided in Section 407.
b. Timing of Disclosure.
Disclosure should be required in annual reports to shareholders. The Section 407 disclosure should not be required until at least one year following promulgation of the rule so that all companies will have an equal opportunity to recruit, if necessary, from what could be a small pool of "financial experts" and avoid whatever stigma investors might apply to companies that either report that they have no financial expert or have no "independent" financial expert on the audit committee.
c. Location of Disclosure.
While this information could be argued to belong in the proxy statement, we believe it would be most relevant in the annual report. The existence of a financial expert on the audit committee is most relevant to the quality of the financial statements. Whether or not an issuer has a financial expert, or the company's explanation as to how the audit committee meets its obligations without a financial expert member, will be most relevant to an investor's confidence in the financial results reported in the annual report.
While one could argue that financial expert is relevant to the corporate governance matters dealt with in proxy materials, one whose sole qualification is that of financial expert would probably detract from the overall quality of the board. Indeed, disclosure in the proxy will unduly emphasize the significance of whether the company has a financial expert as opposed to the more important issues that are disclosed in the proxy.
Disclosure regarding "financial expert" is not necessary in an IPO registration statement because the financial statements contained therein are closely reviewed by the Commission prior to the IPO registration statement becoming effective. The existence of a financial expert on the audit committee becomes relevant once the company has been public for some time and the audit committee's gatekeeper role is most relevant. Therefore, the Commission should adhere to the statutory requirement and limit such disclosure to periodic reports.
d. Frequency of Disclosure.
The Commission has chosen correctly to require the disclosure no more often than annually. Disclosure more frequent than annually would only be a repetition unless the report changed. In that case, a form 8K would almost certainly have already been filed. At most, quarterly disclosure should be required if there is a change in the issuer's financial expert report.
e. Naming the "Financial Expert".
Many disincentives already exist to director service on an audit committee. Publication of the name of the audit committee's financial expert will only add to them. Whether it is matter of fact or perception does not matter. Directors perceive that audit committee members and the financial expert, in particular, will face greater liability after the Sarbanes-Oxley Act. They are not alone. Herbert E. Millstein, "a well-known plaintiff's attorney" recently told an American Bar Association meeting that audit committee members are "`significantly more exposed to liability than in the past.'"12 In the same meeting, Edmund Cronin, chairman of Pepco's audit committee noted that, "`Being the expert is like putting a target on the guy's shirt.'"13 In light of such sobering comments, the disclosure requirement should not include naming the financial expert. Additional disincentive to audit committee service should be avoided if possible.
We believe that the rules that the exchanges have developed on audit committee composition reflect their appreciation of the value that financially savvy directors who are independent of management bring to board service. Their requirements for, and definitions of, an "independent" audit committee member and a "financially sophisticated" member reflect their study of the value that venture capitalists bring to such service. VC directors, representing large shareholdings, are independent of management and knowledgeable about the company and its industry. They also provide financial expertise to audit committees.
There is a risk that some VC directors might not qualify as expert or independent based on overly restrictive definitions of these terms in this rule. It would be an extremely unfortunate result of the Act if newly public companies felt compelled to replace seasoned and financially savvy venture capitalists on their audit committees because they failed to meet overly restrictive definitions of "independent" or "financial expert."
Faced with the choice of disclosing that an audit committee lacks a financial expert or has a non-independent expert, many companies could feel compelled to elect a board member whose only qualification is as an independent financial expert who brings no other value to the board. Likewise, faced with the prospect of serving on a board but not the audit committee, some VC directors may resign from the board as soon as their obligations to their fund investors are satisfied. Neither result will promote good corporate governance nor enhance the ability of the board to help the company deliver long-term shareholder value. Finally, such a result would deny both investors and the economy the benefit that VC directors provide to the companies they help to bring to the public markets.
NVCA would be pleased to provide further input. Please do not hesitate to contact me, or NVCA's outside counsel, Brian Borders at 202-263-3374.
Mark G. Heesen
cc: (Via Messenger)
Harvey L. Pitt, Chairman
Cynthia A. Glassman, Commissioner
Harvey J. Goldschmid, Commissioner
Paul S. Atkins, Commissioner
Roel C. Campos, Commissioner
Allan Beller, Director, Division of Market Regulation
Martin P. Dunn, Deputy Director, Division of Market Regulation
|1||The National Venture Capital Association (NVCA) represents more than 450 venture capital and private equity firms. NVCA's mission is to foster the understanding of the importance of venture capital to the vitality of the U.S. and global economies, to stimulate the flow of equity capital to emerging growth companies by representing the public policy interests of the venture capital and private equity communities at all levels of government, to maintain high professional standards, and to provide research data and professional development for its members.
NVCA member firms provide the start-up and development funding for many companies that go public. Venture funding is a major factor promoting innovation and entrepreneurial businesses. In 2001, venture capital funds invested $41 billion in 3,000 companies. Eighty-five percent of these companies were in information technology, medical/health or life sciences. The success of venture investing is encouraging greater capital flow to these investments. While venture capital investing has fallen off over the past two years from its high in 2000, venture capitalists continue to invest in 2002 and will likely invest the fourth largest amount ever in the history of venture capital this year. Venture capital firms now have an estimated $265 billion under management, up from $30 billion in 1990.
|2|| See Donald C. Hambrick & Eric M. Jackson, Outside Directors With a Stake: The Linchpin In Improving Governance, 42 California Management Review 108 (2000).
|3|| See Charles M. Elson, The Duty of Care, Compensation and Stock Ownership, 63 U. Cin. L. Rev., 649-711 (1995).
|4|| Hambrick & Jackson, supra note 2, at 14-19. Conversely, many argue that outside directors with little or no equity stake in the company do not effectively monitor and discipline the managers who select them. See M. C. Jensen, & W. H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, Journal of Financial Economics, 305-360 (1976). See also Sanjai Bhagat, Dennis C. Carey & Charles M. Elson, Director Ownership, Corporate Performance, and Management Turnover, 54 Bus. Law. 885 (1999).
|5|| Id. at 890-91. In addition, in a more recent article, Professor Bhagat and Stanford Law School Professor Bernard Black conclude that boards with directors that are "independent" (e.g., directors that are not currently officer, or persons who do not have business relationships with the company, such as investment bankers and lawyers) do not achieve improved profitability. Sanjai Bhagat & Bernard Black, The Non-Correlation Between Board Independence and Long-Term Firm Performance, 27 Iowa J. Corp. L. 231, 233, 239 (Winter 2002). Indeed, Bhagat and Black go on to say that their data "hints that greater board independence may impair firm performance." Id. at 233, 263. See also Donald C. Langevoort, The Human Nature of Corporate Boards: Law, Norms, and the Unintended Consequences of Independence and Accountability, 89 Geo. L.J. 797 (Apr. 2001).
|6|| See generally, Hambrick & Jackson, supra note 2, at 6-8 and notes 12, 13 & 15 thereto.
|7|| See generally, Bhagat & Black supra note 5, at 263 (suggesting that inside directors are valuable because, among other things, inside directors are well informed). That is, due to the superior knowledge that inside directors have about the company, as opposed to the "relative ignoran[ce]" of independent directors, inside directors could "`enhance board effectiveness.'" Id. at 264, citing Thomas H. Noe & Michael J. Rebello, The Design of Corporate Boards: Composition, Compensation, Factions, and Turnover, (1997) (working paper, Georgia State Univ. College of Business Administration); and James D. Westphal, Collaboration in the Boardroom: Behavioral and Performance Consequences of CEO-Board Social Ties, 42 Acad. Mgmt. J. 7 (1999).
|8|| See NYSE, Corporate Governance Rule Proposals Reflecting Recommendations from the NYSE Corporate Accountability and Listing Standards Committee, as approved by the NYSE Board of Directors, Part 6, note 5 (Aug. 1, 2002).
|9|| Sarbanes-Oxley Act Section 301 amends the Exchange Act. Exchange Act Sec 3(b)(19) rather obscurely defines "affiliated person," along with "investment company", insurance company", "separate account" and "company" as having the same meaning as under the ICA. The ICA establishes a restrictive and detailed definition of "affiliated person" to include a person who owns more than 5% of the issuer, Investment Company Act, Section 2(a)(3), 15 U.S.C. Sec. 80a-2(a)(3).
|10|| See 17 C.F.R. § 240.12b-2, which defines the term "`affiliate' of, or a person `affiliated' with, a specified person," as "a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the person specified." See also, Securities Act Rule 405, 17 C.F.R. § 230.405, which uses a nearly identical definition of affiliate.
|11|| Disclosure Required by Sections 404, 406 and 407 of the Sarbanes-Oxley Act of 2002, 67 Fed. Reg. 66208, 66212 (Oct. 30, 2002).
|12|| BNA, Daily Report for Executives, Sarbanes-Oxley Raises Liability Issues for Audit Committees, Milstein Says, November 25, 2002, G-12. Millstein also reportedly said, "`I don't know who in his right mind's going to serve on an audit committee.'" Id.