December 7, 1999
Jonathan G. Katz, Secretary
Securities and Exchange Commission
54 55th Street, N.W.
Washington, D.C. 20549
Re: Proposed Rule Changes by National Association of Securities Dealers, Inc. and New York Stock Exchange Amending Audit Committee Requirements Securities Exchange Act Release Nos. 41980, 41981 and 41982; File Nos. SR-NYSE-9939, SR-AMEX-99-38 SR-NASD-99-48
Dear Mr. Katz:
The Committee on Federal Regulation of Securities and Law and the Committee on Accounting (collectively, the "Committees") of the Section of Business Law of the American Bar Association appreciate the opportunity to comment on proposals of the New York Stock Exchange (the "NYSE"), the American Stock Exchange (the "AMEX") and the National Association of Securities Dealers, Inc. (the "NASD") to change their respective rules regarding the establishment of audit committees by companies listed or seeking to list on the respective securities markets subject to their oversight. We refer to the NYSE, the AMEX and the NASD for convenience collectively as the "Exchanges". This comment letter has been prepared by certain members of each of the Committees, and a draft of this letter was circulated for comment among select members of each of the two Committees and others within the Section of Business Law. All persons generally agreed with the substance of this draft. However, our letter does not represent the official views of the Association, the Section on any of their committees or subcommittees.
Although the Committees believe that the establishment of effective audit committees could have a beneficial impact upon financial reporting, they are concerned that certain of the recommendations of the Blue Ribbon Committee that have been included in the proposals may be misdirected. As you are aware, all listed companies are required to have audit committees and the problem addressed by the Blue Ribbon Committee was how to make those audit committees more effective.
The Blue Ribbon Committee, the Exchanges have proposed to accomplish this goal by requiring that audit committees be composed of financially sophisticated and "independent" directors, and that the board of directors of a listed company adopt a formal charter for the operation of its audit committee. The Blue Ribbon Committee further suggested that the SEC adopt certain disclosure rules to provide further incentive for audit committees to properly carry out their duties. We have two principal concerns with this overall approach: First, we are troubled by the use of a rigid "independence" concept when we believe the primary concerns should be objectivity and integrity. Second, unless minimum requirements governing the operations of audit committees become accepted practice, we believe the entire mechanism will lose its impact. This latter concern, however, must be balanced with recognition of the need to maintain flexibility so as to make the system workable for all public companies.
Independence. As far as we know, no empirical data have been compiled with respect to whether or to what extent audit committees have not been functioning properly. Nevertheless, the Blue Ribbon Committee appears to have concluded that audit committees have not been effective because they have lacked independence from company management. We understand that if audit committees are composed of persons with close ties to their company's management, they may not function effectively. Nevertheless, we do not believe that lack of independence (defined in an arbitrary and rigid manner) is necessarily the root of the problem. From our perspective, the critical issues are diligence, objectivity and integrity; and those qualities may be lacking whether or not rigid independence standards have been satisfied, and may be present when such standards have not been met. Accordingly, we support in general a more flexible approach that allows the board to assess all important criteria, rather than be restricted by a single criterion of perhaps lesser importance.
The Exchange proposals differ from each other and from the recommendations of the Blue Ribbon Committee. Although we recognize that there are qualitative differences among the companies listed on the several Exchanges, we believe that the need for audit committee members who possess the qualities of diligence, objectivity and integrity are common to all publicly held companies and, therefore, we suggest that the Exchanges adopt uniform standards for all audit committees, preferably those proposed by the NYSE incorporating the flexibility for boards to make the necessary judgments.
Some members of our Committees were in favor of imposing strict minimal independence standards as a means of assuring the selection of audit committee members who would serve the interests of the company's shareholders and the investing public. On balance, however, the Committees support the approaches taken by the Exchanges, particularly the NYSE, which utilize some, but not all, of the independence criteria suggested by the Blue Ribbon Committee and emphasize the importance of the board's use of it's own criteria to recruit and appoint qualified and dedicated members to the audit committee. All board members must bear responsibility for the performance of the audit committee. However, there is a serious question whether a board member should be able to rely upon the performance of an audit committee whose members lack the requisite qualities of diligence, objectivity and integrity. It is for these reason that we favor the approach that largely places the determination of independence, financial literacy and expertise in the discretion of the Board.
Although we generally favor the approach taken by the NYSE proposals, we recommend the following three modifications to those proposals:
1. We see no reason to flatly preclude a former employee of the company from serving as an audit committee member if that employee did not serve in an executive capacity. While a former executive officer of the company would likely have personal ties to the company's management, requiring a cooling-off period, we see no need for such a mandatory cooling-off period for non-executive level employees if the Board can make the requisite determination regarding independent judgment. Accordingly, we would treat former non-executive employment as a business relationship.
2. We are also concerned with the NYSE's proposal with respect to immediate family members, which only encompasses those who hold executive positions. Here, the emphasis should not be on the relationship to management, but rather the potential threat to thelivelihood of the immediate family member. Accordingly, we believe that any position held with the company by an immediate family member should disqualify a director from service on the audit committee.
3. The NASD proposal addresses explicitly directors who also serve as a consultant to the company, whereas the NYSE proposal leaves it to the general concept of business relationships. We believe that a consultant who receives from the company more than a de minimus amount representing a substantial part of his or her income, should be treated as an employee, while a consultant who does not, regardless of the amount, should be treated as having a business relationship which the board can determine does not impair the director's objectivity.
Missing from the NYSE's (but not the NASD's) list of independence criteria is one aimed at the amount of compensation earned by an audit committee member. Even though we have concerns that an audit committee member deriving a substantial amount of his or her annual income from the company might subordinate his or her objectivity in assessing accounting positions taken by management, we do not recommend such a criterion out of a concern that it might preclude a number of highly qualified persons (such as retired auditors and financial officers and university professors) from serving as an audit committee member. In addition, we are concerned that the receipt of valuable stock options and other compensation necessary to attract qualified persons may disqualify numerous qualified persons under a rigid independence standard.
Financial Sophistication. The corporate laws of almost all states assume that members of a board of directors will not be able personally to ascertain the financial condition of their company and will be forced to rely upon the financial reports of independent auditors. While we believe that this assumption properly characterizes most corporate boards, we believe that boards of directors should take greater responsibility for financial disclosures. To do this, boards of directors should possess a significant degree of financial sophistication. The proposed rules require that audit committees be composed of at least three persons, all of whom must possess financial literacy and one of whom must have had experience in financial accounting or management. Although we have some concerns whether the boards of directors of most public companies have at least three independent members who satisfy the financial sophistication requirement, we believe that this competence requirement should not be compromised.
On the other hand, we are more concerned that many public companies will not have an independent director who has specific accounting or financial management experience. In addition, there are many outstanding directors with the requisite financial acumen who come from other backgrounds (such as investment bankers and, if we may be so bold, securities lawyers), and they should not be excluded. Even if a company has a director who can provide the specified experience, there will be reluctance for any one director to accept responsibility, with the added exposure to liability, of being the "financial expert." Rather than defining individual requirements, we recommend that the board be required to appoint an audit committee that, as a whole and taking into account the relevant background, education and experience of its members, has the requisite financial literacy and experience to properly perform its duties.
Also as noted above, we approve of the approach taken in the NYSE proposal which makes the Board the arbiter of these experience requirements.
Audit Committee Charters.
One of the most important aspects of the Blue Ribbon Committee's Report was that it provides guidance to audit committees regarding the scope of their responsibilities. The proposals of the Exchanges, however, lack specificity as to the contents of audit committee charters; and a number of our members expressed concern that this might lead to the adoption of charters with minimal requirements. While the report of the Blue Ribbon Committee itself, at least for the moment, will increase the level of consciousness of audit committees regarding their responsibilities, there remains a potential danger that, with the passage of time, audit committee members may lose sight of their duties. Thus, audit committee charters with aspirational language, but lacking specificity, may do little to correct this potential problem. Notwithstanding these concerns, our Committees believe that it is important to allow the board of directors to have flexibility in establishing its own audit committee charter, both because of the wide range of variance among the businesses of different companies and the challenges faced by, and constituency of their boards of directors, and because of the importance of encouraging creativity in this largely unexplored area. Accordingly, we support the proposal of the NYSE, which leaves unstated the contents of an audit committee charter.
Exceptions for Smaller Issuers
We understand that the requirements to be imposed by the Exchanges involve burdens that might be difficult for some small public companies to sustain. We also recognize that those companies could derive the greatest benefit from a properly functioning audit committee. Therefore, we believe that there should be no across-the-board exception for smaller public companies. Nevertheless, we do support the limited exceptions set forth below.
There can be no question that smaller public companies (e.g., those with market capitalizations of less than $200 million) will likely have fewer directors and will have greater difficulty attracting persons who have the requisite qualifications to serve on an audit committee of a public company. Accordingly, we believe that such companies should be permitted to have an audit committee of as few as two members. For the same reason, we also believe that it may be difficult for such companies to obtain the service of directors with the requisite accounting background. We, therefore, believe that, if a requirement for an audit committee member with accounting or financial management experience (as opposed to financial literacy) is retained, it should not apply to smaller public companies.
Exception for Registered Investment Companies
We believe it would also be appropriate to create an exception to the audit committee listing requirements for registered investment companies, whose audit committee members are already required not to be "interested persons" as that term is defined in Section 2(a)(9) of the Investment Company Act. In making this recommendation, we would like to point out that there have been few, if any, financial statement problems encountered among registered investment companies. Moreover, the accounting principles associated with investment companies tend to be more straight-forward and less complex, further justifying such an exception.
We appreciate this opportunity to comment on the proposal and should you have any further questions, we would be pleased to meet with the representative of the Commission's staff. In this regard, please contact Richard Rowe at (202) 416-6820 or Dan L. Goldwasser at (212) 407-7710.
/s/ Stanley Keller
Chairman of the Committee on
Federal Regulation of Securities
/s/ Richard Rowe
Chairman of the Committee on
Law and Accounting
Dan L. Goldwasser, Chair
Edward H. Cohen
Richard H. Rowe
Lawrence P. Scriggins
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