February 18, 2003


File No. S7-02-03 - Standards Relating to Listed Company Audit Committees

Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington D.C. 20549

Dear Mr. Katz:

We appreciate the opportunity to comment on the Commission's Proposed Rule relating to listed company audit committees ("Proposed Rule"). Based on our experience in representing foreign private issuers, we would like to offer several recommendations below.

The government shareholder exception to the audit committee member independence requirement should be modified to clarify that all forms of government holdings in foreign private issuers are covered.

We very much support the concept of granting an exemption from the independence requirement of audit committee members for a "representative or designee of a foreign government or foreign governmental entity that is an affiliate of the foreign private issuer." We believe that it would be helpful if the Commission could clarify that the exemption applies not only to foreign governments that hold their stakes directly, but that entities administering a state holding also fall under this exemption regardless of their legal form.

In Europe, state interests in companies are held and administered in many different forms. In addition to direct ownership, governments may hold their interests through entities with a special corporate form or in the form of stock corporations, development banks and other public and private sector institutions. A few examples from a number of continental European jurisdictions are as follows:

  • In Italy, the Treasury holds shares of Italian companies both directly, such as its stake in Alitalia, and indirectly through holding companies in which the Treasury holds a 100 percent interest and for which the Treasury generally appoints the boards of directors, such as its stake in the Italian State Television (RAI TV), held through Rai Holding S.p.A.

  • In Germany, in addition to certain direct holdings, the federal government holds shares in companies indirectly through the Kreditanstalt fűr Wiederaufbau ("KfW"), a state development bank.1 For example, KfW currently holds the German government's interest in Deutsche Telekom Aktiengesellschaft and Deutsche Post AG.

  • In Austria, state interests are generally held indirectly, either by a special purpose vehicle or by the Ősterreichische Industrieholding Aktiengesellschaft ("ŐIAG") through the Federal Minister of Finance.2

  • In Spain, state interests are principally held through state-owned public entities (entidades publicas) such as the Sociedad Estatal de Participaciones Industriales. The Ministry of Finance generally selects the board of directors of such public entities and its approval is required prior to the undertaking of significant transactions in the shares of companies in which the state holds an interest.

Thus, sometimes state holdings are held directly by a branch of the government, sometimes by an institution organized under public law and sometimes by an entity organized as a stock corporation. In each case the mechanisms for and degree of state control will vary depending on the local legislation and the form or organization. We do not believe that either the legal form of the entity which holds the governmental shareholdings or the precise mechanism used for state control should be determinative of qualification for the independence exemption. The term "foreign governmental entity" therefore should be read as to include any kind of company, entity or other organization which is entrusted with the administration and representation of the state's holdings in a foreign private issuer. We attach as Annex A a proposed clarification of the term "foreign governmental entity".

The controlling shareholder exemption to the audit committee member independence requirement should be modified for consistency with a broader range of home country laws.

We also very much support the concept of an exemption from the independence requirement of audit committee members for one shareholder or a representative of a shareholder or group that controls the foreign private issuer, so long as this representative has only non-voting observer status on the audit committee and is not an executive officer. The Proposed Rule explains that outside of the United States "...controlling shareholders have traditionally played a more prominent role in corporate governance. In jurisdictions providing for audit committees, representation of controlling shareholders on these committees is common."

However, we believe that using as the measure of control the ownership of more than 50% of the outstanding voting securities of a foreign private issuer may inadvertently narrow the scope of the intended exemption, in failing to take into account important differences between the corporate law systems and corporate governance practices in the United States and in Europe. Because of these differences, a shareholder can clearly be, and is considered, a controlling shareholder in many European jurisdictions at ownership levels below 50% of outstanding shares.

Generally speaking, in the United States, beneficial ownership of over 50% of outstanding shares of a corporation is of fundamental importance in a number of corporate control situations. State corporation laws generally specify voting majorities for important issues based on shares outstanding. For example, the Delaware General Corporation Law ("DGCL") requires the vote of a majority of the outstanding voting shares for every amendment to the certificate of incorporation (DGCL §242(b)(1)), for the adoption of a merger agreement (DGCL §251(c)) and for the passing of a shareholders resolution taken by written consent (DGCL §228). Likewise under New York's Business Corporation Law ("NYBCL"), an amendment to the certificate of incorporation (NYBCL §803), adoption of a merger agreement (NYBCL §903(a)(2)) and an action taken by written consent (NYBCL §615(a)) each requires the vote of a majority of the outstanding voting securities.

In contrast, under European laws, the required majorities (whether a simple majority or a qualified majority) for significant corporate actions are generally based on shares represented at the shareholders meeting.3 A number of factors contribute to this difference in approach to shareholder majorities between the United States and Europe.

  • Traditionally, most of the shares issued in Europe have been bearer shares, whereas in the United States state corporation laws contemplate shares issued in registered form.

  • Under state corporate law systems in the United States, corporations can generally use their shareholders' list to determine who is entitled to vote. In Europe, corporations give notice of a meeting by publication and by sending materials to financial institutions. Due to the absence of a shareholder list in the case of bearer shares, shareholders generally have to register to attend a shareholders meeting at least three days prior to the meeting and deposit with the issuer or a financial institution the certificates evidencing the shares they wish to vote.

  • Like the U.S. practice, the European systems also grant shareholders the right to assign to another the power to vote their shares. However, rules differ as to the conditions under which financial institutions must forward proxy materials to shareholders and in some jurisdictions it has not been possible to grant proxies to management or employees of the corporation, so that the number of outstanding shares actually voted is usually much smaller.

For these reasons the attendance at shareholders meetings is usually much lower than in the United States and a shareholder owning less than 50% of the outstanding voting shares can effectively exercise control of the corporation. Many national takeover boards have reflected this reality in the percentages required for a shareholder to have deemed control of a corporation.4

Considering the factors cited above, we suggest the Commission modify the proposed control threshold for the purpose of the controlling shareholder exemption. We propose that the Commission apply the 50% test to the number of shares represented at the last shareholders meeting of the foreign private issuer and propose that Rule 10A-3(b)(1)(iv)(D) be changed as attached in Annex B. We believe that this change will more closely reflect the corporate law systems in Europe and is thus more appropriate to carry out the Commission's intention of allowing foreign private issuers to continue the current practice of the representation of controlling shareholders on their audit committees.

Foreign private issuers that have a board or body of statutory auditors should be given the option to divide responsibilities between an audit committee composed of independent directors as required by the Proposed Rule and a board of statutory auditors.

We support the exemption contained in the Proposed Rules to the independent audit committee requirement and the auditor oversight requirement for foreign private issuers which have independent boards of auditors established pursuant to home country legal or listing provisions. The exemption recognizes that statutory auditor schemes in some countries may impose certain duties on a board of auditors that, under the Proposed Rule, are required to be the responsibility of the audit committee, and that accommodation of such foreign practices is consistent with the intention of the Sarbanes-Oxley Act to separate these duties from management.

However, certain of the obligations that are required by the Proposed Rule to be handled by an audit committee may not be legal obligations of a foreign private issuer's board of statutory auditors in the relevant country. For example, Italian law expressly provides for the statutory auditors to handle the complaints of shareholders, but makes no specific provision for the confidential, anonymous submission of complaints by employees. Although complaint procedures for any other person, including employees, may be established by the board of statutory auditors in Italy, we believe Italian companies and other similarly situated companies should be permitted to retain this or other responsibilities within an audit or similar committee so long as the independence requirements of the Proposed Rule are satisfied.

A foreign private issuer that qualifies for the statutory auditor exemption should have the option to divide responsibilities between its board of statutory auditors and an audit committee of its board of directors (or other committee that fulfills such function), so long as:

  • both bodies are independent in accordance with the Proposed Rule, and

  • between the two, the required responsibilities of the audit committee as set forth in the Proposed Rule are satisfied.

We would respectfully request the Staff to permit such a division of responsibilities to allow such a foreign private issuer to comply with the substance of the Proposed Rule without facing either the duplication of responsibilities or the reallocation of such responsibilities between existing independent bodies.

The rule should make clear that foreign government issuers are excluded from its requirements.

The proposed audit committee requirements apply to "issuers" of listed securities. Although the audit committee member independence requirements are plainly meant to apply only to foreign private issuers (See Release Nos. 33-8173; 34-47137; IC-25885 at Note 82), the rules themselves do not make this clear. As was done in the Final Rule: Implementation of Standards of Professional Conduct for Attorneys,5 we believe the rule should include a definition of issuer for the purposes of Rule 10A-3 that explicitly excludes foreign government issuers.

The rule should allow a longer transition period for foreign private issuers.

The Proposed Rule requires that the new audit committee listing standards be operative by the national securities exchanges and national securities associations no later than the first anniversary of adoption of the Commission's final rules, which is expected to be in April 2003. Therefore, issuers, including foreign private issuers, would need to put in place a compliant audit committee by April 2004.

We believe that one year is an inadequate transition period for foreign private issuers, for whom the audit committee requirements represent a significant departure from current practices. Many foreign private issuers do not have audit committees that resemble U.S. audit committees. Those that do have such audit committees currently comply with home country requirements and practices, including home country definitions and requirements, if any, relating to the independence of audit committee members.

Not only are the audit committee requirements significant departures from the current practice in many countries, but we have been told that the pool of people available in those countries qualified to perform the functions required of audit committee members under the Proposed Rule and who may therefore serve on audit committees of issuers with U.S. public shareholders is relatively small. It may not be feasible for many foreign private issuers to quickly locate and attract new directors who are both independent under the Proposed Rule and sufficiently knowledgeable about U.S. and home country accounting and financial reporting issues and about the issuer's industry to fulfill the role envisaged by the Proposed Rule for the audit committee.

To be in compliance by April 2004, foreign private issuers that hold their annual shareholders meeting in January, February or March would need to review the necessary changes to their corporate governance structure and find new candidates for directors in time to propose them for election at the annual shareholders meeting taking place in the first quarter of 2004. Even greater difficulties would be faced by those foreign private issuers which hold their annual shareholders meeting in April, May or June, since their only options for compliance would be to make the necessary corporate governance changes this year or to hold a time-consuming and potentially disruptive special shareholders meeting prior to April 2004.

We believe that the interests of U.S. investors would be better served if foreign private issuers were given sufficient time to choose qualified directors who fulfilled the new independence rules and could sufficiently perform the additional duties imposed by the Proposed Rule and the Commission's recently adopted Final Rule: Strengthening the Commission's Requirements Regarding Auditor Independence,6 rather than being compelled to put in place a new team of directors who may be "independent" under the Proposed Rule but who may not otherwise be as qualified as would be desirable.

In light of these difficulties, we urge the Commission to allow a two-year transition period for foreign private issuers. While such a period is still short and, we believe, sufficiently responsive to the issues addressed by the Sarbanes-Oxley Act, the additional time would enable foreign private issuers to comply with the new rules in a meaningful and productive manner, to the benefit of U.S. investors, without undue disruption to the regular corporate calendars of these issuers.

The rule should build in flexibility to adapt to evolving standards of corporate governance throughout the world and permit additional exemptions for foreign private issuers as countries adopt new standards.

Corporate governance is an issue currently being addressed in many countries and in international organizations such as IOSCO and the European Commission. Corporate governance standards are evolving at a rapid pace throughout the world and are most often aimed at the prevention of the same types of abuses as those targeted by the Sarbanes-Oxley Act. Many home country standards relating to director independence and to audit committees may offer, and will offer in the future, alternatives to those established by the Proposed Rule, some of which may conflict with the Proposed Rule. We believe that the U.S. rules should be flexible enough to permit recognition, on a case-by-case basis, of the corporate governance rules and practices applicable to a foreign private issuer, particularly when they conflict with the U.S. rules or standards.

While the Proposed Rule does attempt to address the concerns of foreign private issuers in specific areas where foreign legal requirements conflict with the Proposed Rule requirements, the release also states that there will be no other ability for an exchange to exempt or waive a foreign private issuer from the proposed requirements. Instead of this approach, we believe that the Commission should have the flexibility to grant exemptions in future cases where home country standards and practices, taken as a whole, related to audit committees and auditors are in conflict with U.S. corporate governance rules or are different from U.S. standards but equally protective of U.S. investors. Such flexibility would not be without precedent, as the U.S. securities laws have traditionally permitted diversity with respect to corporate governance for foreign private issuers as a matter of international comity when the interests of U.S. investors are not harmed. We would urge the Commission either to grant such flexibility to the national securities exchanges or national securities associations or to retain such flexibility through the no-action process as it recently did in connection with the Final Rule: Strengthening the Commission's Requirements Regarding Auditor Independence.7

We hope that the foregoing is helpful to you as you consider the Proposed Rule. Please do not hesitate to contact Margaret E. Tahyar at 011-33-1-56-59-36-70 in Paris or Nick Kronfeld at 212-450-4950 in New York if you would like to discuss these matters further.

Davis Polk & Wardwell

1 KfW is owned 80% by the Federal Republic of Germany and 20% by German federal states. KfW is a public law institution serving public policy objectives of the German Federal Government organized under the Law Concerning the Kreditanstalt fűr Wiederaufbau.
2 The supervisory board of ŐIAG consists of 15 members, ten of which are managers or business experts whose successors are elected by the supervisory board members themselves to assure their independence and five of which are nominated by the Austrian Chamber of Labor from the workers' councils of major subsidiaries of ŐIAG and appointed by the shareholders' meeting.
3 Under the Austrian Stock Corporation Act, certain matters such as the amendment of the business purpose, increase of the share capital, mergers, spin-offs and the transfer of all of the company's assets require a majority of 75% of the votes represented at the shareholders meeting rather than a majority based on the number of shares outstanding. Likewise under the German Stock Corporation Act and German Restructuring Act, the amendment of the business purpose, increase of the share capital, mergers, spin-offs and the transfer of all of the company's assets requires a majority of 75% of the votes represented at the shareholders meeting.

In France, under the French Commercial Code any modification of the articles of a stock corporation and the adoption of a merger agreement require a two-thirds majority vote of the shareholders assembled at a special shareholders meeting.

In Italy, under the Italian Civil Code, any modification of the articles of a stock corporation or a listed company and the adoption of a merger agreement by a listed company require a two-third majority of the shareholders assembled at a special shareholder meeting.

In the United Kingdom, the Companies Act 1985 requires certain matters, such as amendment of the articles of the corporation and the reduction of the corporation's capital to be adopted by a special resolution in a shareholders meeting by a 75% majority of the votes present at a general shareholders meeting.

In Spain, under the Spanish Corporate Law Statute, the resolutions adopted at a special shareholders meeting related to the amendment of articles, the approval of a merger agreement and the issuing of securities require two thirds of the votes present and cast at the meeting.

4 The German takeover regulation, the Act on Acquisition of Securities and Takeovers, adopted in 2002 defined "control" as the holding of at least 30% of the voting rights. This presumption of control at a 30 or 33-1/3% is common to many European takeover statutes which require a shareholder who passes this threshold to make a "mandatory offer" to all other shareholders. See for example, the London City Code on Takeovers and Mergers (30%), the French Tender Offer Rules (33-1/3%), Austria's Takeover Law (30%) and the Spanish Takeover Law (25%).
5 SEC Release Nos. 33-8185; 34-47276; IC-25919 (January 29, 2003) at 53 ("Issuer means an issuer (as defined in section 3 of the Securities Exchange Act of 1934 ...) but does not include a foreign government issuer.").
6 SEC Release Nos. 33-8183; 34-47265; 35-27642; IC-25915; IA-2103, FR-68 (January 28, 2003).
7 Id.

Annex A

We suggest that an explanatory note with respect to the meaning of "foreign governmental entity" in the listing standards relating to audit committees pursuant to Rule 10A-3(b)(1)(iv)(E) of the Exchange Act be added as follows:

"For purposes of the determination by the board of directors under this Rule 10A-3(b)(1)(iv)(E), "foreign governmental entity" means any entity (however organized, whether by specific legislation, under home country corporate law, public law or otherwise) which holds the state's ownership interest in a foreign private issuer."

Annex B

We suggest that the exemption from the independence requirement in Rule 10A-3(b)(1)(iv)(D) should be modified as follows (modifications in bold):

    "(1) The member is a beneficial owner of more than 50% of the voting common equity of the foreign private issuer represented at the last shareholders meeting of the issuer or is a representative or designee of such an owner or a group of owners that collectively are the beneficial owner of more than 50% of the voting common equity of the foreign private issuer represented at the last shareholders meeting of the issuer;

    (2) The member has only observer status on, and is not a voting member or the chair of, the audit committee; and

    (3) The member is a not an executive officer of the foreign private issuer.