February 18, 2003
Mr. Jonathan G. Katz, Secretary
Re: File No. S7-02-03
Dear Mr. Katz:
We at PricewaterhouseCoopers LLP appreciate the opportunity to comment on the Commission's Proposed Rule: Standards Relating To Listed Company Audit Committees (the "proposal(s)" or the proposed rule(s)").
We share and support the recent efforts by Congress and the Commission to restore investor confidence. Clear and unambiguous rules for audit committees, companies, and audit firms are needed to accomplish this.
The proposed rule aimed at improving corporate governance of listed companies are substantive and reflect and build on what has been shown to be best practice among leading companies and their audit committees. In addressing many key issues surrounding the current crisis of confidence in the U.S. system of corporate governance and financial reporting, the proposed rule provides important elements on which the public trust can be renewed, enhanced and sustained.
We support the overall thrust of the proposed rule, and believe it will appropriately strengthen the fiduciary role of audit committees and bring an appropriate balance in the conduct of audit committees. However, as described in the attachment to this letter, we believe that the Commission should extend the implementation date for foreign private issuers until a minimum of two years after the publication date of the final rules. We have included in the attachment to this letter our detailed responses to the questions posed in the proposed rule.
We appreciate the opportunity to express our views and would be pleased to discuss our comments or answer any questions that the staff may have. Please do not hesitate to contact James F. Harrington (973-236-7203), Marie Kling (973-236-4695) or Wayne Carnall (973-236-7233) regarding our submission.
Attachment - Responses to detailed questions
While the wording of the compensatory fee prohibition is generally adequate, we believe that clarification is warranted in certain areas.
We recommend that the Commission clarify whether compensation under a retirement plan or similar plan where the amounts are pre-determined and not contingent upon a future event is considered to impair independence. Our position on this matter is conceptually consistent with the recommendation submitted to the Commission by the New York Stock Exchange on August 16, 2002, which excludes non-contingent retirement payments from its proposed independence requirements. We suggest that the Commission further consider incorporating in its proposed rule some of the wording included in its release No. S7-49-02 entitled "Strengthening the Commission's Requirements Regarding Auditor Independence" as it pertains to the employment at an audit client of a former employee. This release would require that the individual has no financial arrangement other than one providing for regular payment of a fixed dollar amount (which is not dependent on the revenues, profits, or earnings), pursuant to a fully funded retirement plan, rabbi trust, or, in jurisdictions in which a rabbi trust does not exist, a similar vehicle.
In addition, we would support the addition of a de minimis exception for the compensatory payments based on a small percentage of the fees received. This percentage could be set at 5% of annual fees received. We view this as a practical way of eliminating small, inadvertent and inconsequential payments made to the audit committee member.
We believe that the rules are intended to ensure that an audit committee is independent, both in fact and appearance. Indeed this is crucial to investor confidence. Independence in appearance demands that a reasonable person with knowledge of the interests of an audit committee member would conclude that the member is able to exercise independent judgment. Compensation paid to an entity involving the circumstances described - where some may deem an indirect payment to have been made to an audit committee member raises concerns about the appearance of independence, in a manner similar to the concerns raised by direct payments. As a result, we agree with the Commission's extension of the compensatory prohibition to "indirect payments". However, as stated in our answer to question 1 above, we believe that a de minimis exception should be included in the final rule.
In addition, we do not believe that the prohibition should be extended to ordinary course of business relationships. However, we would encourage the Commission to provide guidance around the definition of an ordinary course of business relationship, as it pertains for example to relationships with affiliated financial institutions, and/or customers and vendors.
We believe that the definition of an affiliated person for non-investment companies is adequate. However, we believe that the clarification that a director, executive officer, partner, member, principal or designee of an affiliate would be deemed to be an affiliate is needed. We indeed share the view expressed by The Business Roundtable in its 2002 Principles of Corporate Governance that attention should be given to close personal relationships between an audit committee member and senior management that might affect a director's actual or perceived independence.
We further agree with the inclusion of the safe harbor provision. However, we would suggest modifying that provision to include a rebuttable presumption that those individuals who cannot rely on the safe harbor provisions are considered affiliated persons. This presumption could be rebutted by a consideration of the individual facts and circumstances, which, in our view, should focus on the audit committee member's ability to exercise "control", and not merely on the actual exercise of control.
We do not believe that a subjective test by itself would achieve the desired objective. As the Commission stated in its proposed rule, there are a variety of contractual arrangements with different control features. We do not believe that those arrangements can exhaustively be captured by exclusive reliance on a subjective test. Our recommendation on this issue is described in our answer to Question 3 above.
We believe that it is not possible to anticipate, or explicitly provide for all circumstances that might signal potential conflicts of interest, or that might bear on the materiality of an audit committee's relationship to a listed company. As such, we believe that the board of directors is best equipped to make that determination based on all the relevant facts and circumstances. This view is consistent with the view that we expressed in our response letter to the Commission's proposed rule entitled "Proposed Disclosures About Financial Experts Serving on a Company's Audit Committee".
In addition, we believe it is useful to investors for the company to disclose the considerations used by the board of directors in determining that an audit committee member met the independence requirements.
In our view, a look back period would not be necessary. A mandatory look-back or cooling-off period may promote the "appearance" of independence more completely, and might eliminate the risk that the audit committee member could be unduly influenced through his or her previous involvement with the issuer. However, we believe that the costs in terms of experience and expertise with the issuer's business and structure would largely outweigh the benefits. In addition, we do not believe that one particular look-back period, be it one year or five years would erase the appearance that the audit committee member was once associated with the issuer.
As a result, we believe that the focus should be on current relationships. In this context, we believe that outstanding balances due directly or indirectly to a potential audit committee member would need to be assessed, to determine whether the collection of those amounts may impair independence. However, we do not believe that disqualifying an independent auditor who may have received fees in the past and who is no longer subject to the conflicts that such payments have posed in the past is warranted.
If the Commission were to decide that a look-back period is necessary, we recommend making that period consistent with the current requirements for members of an audit engagement team, as recently adopted by the Commission in its release S7-49-02 entitled "Strengthening the Commission's Requirements Regarding Auditor Independence".
We believe that the two criteria included in the proposed rule are appropriate, subject to the various comments that we have expressed in the remainder of this letter.
We do not believe that any particular relationships should be exempted from the requirements, besides the exemption for relationships in the ordinary course of business. We believe that board of directors need to make a careful analysis of all the facts and circumstances.
We believe that the 90 day-exemption is adequate. In our view, it would achieve an adequate balance between the need for independence and the need for historical knowledge and experience with the company.
We believe that the proposed exemption is generally appropriate. We believe that if an audit committee member of a parent is otherwise independent, merely serving on the board of a controlled subsidiary should not adversely affect the board member's independence, assuming that the board member would also be independent of the subsidiary except for the member's seat on the parent's board. There are usually valid business reasons for the overlap amongst the various boards of directors and we believe that such an exemption would achieve a right balance between independence and the relevant expertise needed by the audit committee member to perform its duties.
We would further encourage the Commission to allow a similar exemption for other situations where there may be a valid business reason for an overlap between a parent and one or several entities. For example, we believe that it would be appropriate to also provide an exemption for unconsolidated 50% owned joint-ventures with only listed debt securities.
We do not believe that there should be an exception based on limited or exceptional circumstances, such a provision could be subject to abuse and misinterpretation. As stated above, there needs to be in our view, a consistent and rigorous application of the requirements.
In addition, we are of the view that disclosure of a "dependent relationship" cannot be a substitute for the requirement to maintain independence.
As it relates in particular to investment company audit committees, we do not believe there should be any exemption to permit non-independent Board members to serve on investment company audit committees. Unlike other entities, Section 10 of the Investment Company Act of 1940 requires at least 40% of a registered investment company's Board to be "disinterested" members. The Commission has largely adopted the 1940 Act "disinterested" standard as the independence standard for investment company audit committee members. As such, at all times there should be sufficient independent Board members to constitute an audit committee under the proposed listing standards.
We do not believe that any provisions should be made for providing exemptive relief.
Please refer to our answer to Question 11.
Auditor responsibility requirements
We believe that those provisions meet the spirit of the Act to have an independent audit committee, separate from management responsible for hiring, terminating, and overseeing the work of independent auditors. We support the thrust of the proposed rules to further focus audit committee attention on overseeing the external auditor's activities, with more in-depth probing and a healthier discussion of significant accounting, auditing, and financial reporting issues.
We encourage the Commission to clarify the particular level at which the auditor responsibility requirements would apply. Rule 10A-3(b)(1)(iv)(F)(2)(i) requires the audit committee of a listed issuer to be responsible "for the appointment, compensation, retention, and oversight of the work of any registered public accounting firm engaged for the purpose of preparing or issuing an audit report... or performing other audit, review or attest services for the listed issuer...". The narrative section of the proposal suggests that this provision was intended to apply only to the auditor of the listed issuer's financial statements, particularly because the narrative specifically states that it is intended to reinforce Section 202 of the Sarbanes-Oxley Act. However, as literally written, this provision would apply to any auditor performing audit or attest services for the company, whether or not the auditor is the auditor of the listed company's financial statements, whether or not distribution of the audit or attest report is limited to only specified parties, and whether or not the report was intended to be used in a filing with the Commission. We believe that the application of this provision should be limited to the auditor of the listed company's financial statements and any audit or attest reports provided by other auditors and included or required to be included in a filing with the Commission.
Internal Audit is a management function and a key component of the internal control structure of the issuer. Footnote 2 of AU 322, The Auditor's Consideration of the Internal Audit Function in an Audit of Financial Statements, states that: " although internal auditors are not independent of the entity, the Institute of Internal Auditors' Standards for the Professional Practice of Internal Auditing defines internal auditing as an independent appraisal function and requires internal auditors to be independent of the activities they audit".
To ensure the necessary independence of the internal auditor in the performance of its duties, we support a dual reporting structure both to management and the audit committee, which includes, in all instances, a direct relationship between the audit committee and the internal auditor. This direct relationship should ensure that: (1) the internal auditor has regular access to the audit committee and (2) the internal auditor attends formal audit committee meetings and meets privately with the audit committee, periodically but not less frequently than annually.
We believe that the proposed instruction properly addresses those concerns.
We believe that the Section 32(a) requirements should be retained. We note, however that, Rule 10A-3(b)(i)(iv)(F)(2)(ii) exempts audit committees of registered investment companies from the requirement for direct "selection" of a registered public accounting firm required in Rule 10A-3(b)(i)(iv)(F)(2)(i). However, the word "selection", which appears to have been derived from Section 32(a) of the 1940 Act, does not conform to the Rule 10A-3(b)(i)(iv)(F)(2)(i) terminology of "appointment" and "retention". We recommend that the wording of Rule 10A-3(b)(i)(iv)(F)(2)(ii) be conformed to that of Rule 10A-3(b)(i)(iv)(F)(2)(i) for clarity.
Existing 1940 Act requirements, including Section 32(a) and Rule 32a-43, when combined with the new requirements for audit committee pre-approval of audit services, substantially achieve the intended goals of the proposal. We do not believe compliance should be required with the proposed rule in addition to the 1940 Act requirements.
Please refer to our response to Question 18.
Complaints procedures requirements
We believe that many issuers have procedures, however the extent and detail of those procedures varies among issuers.
We do not believe that specific disclosures in Commission filings are necessary. While we acknowledge the fact that these disclosures may be meaningful to investors, we believe that there needs to be a balance between relevant information and information overload. We do believe that the procedures should be published within the listed company's internal policies to ensure that persons seeking to avail themselves of the mechanism can do so.
While we believe that each company will ultimately have to tailor its procedures to its own facts and circumstances, certain guidelines should be provided to ensure the processes follow a minimum standard of quality. Those guidelines could address typical practices that issuers would have to put in place such as the development of training and policies to educate employees and the establishment of a rigorous process for reporting questionable accounting or auditing matters.
In addition, the Commission should consider clarifying the definition of "employee" for purposes of establishing procedures to receive and investigate complaints by listed investment companies, as investment companies rarely have direct "employees". We believe that, for investment companies, the definition should include employees of those entities that are engaged by the fund to prepare or assist in preparing the fund's financial statements.
Authority to engage advisors requirements
We believe that the requirements as currently worded are adequate.
We do not believe that additional specificity is needed. However, see our answer to Question 25 below.
We support the requirement included in the proposed rule that the issuer provide for appropriate funding, as determined by the audit committee, in its capacity as a committee of the board of directors, for compensation of the independent auditor and any advisors engaged by the audit committee. We do not believe that the Commission should include a compensation limit in its rules.
Compensation for an audit engagement will vary significantly among companies based on the complexity of the audit, the business of the issuer, the reliance on internal audit (if applicable) etc...We are of the view that since audit committees are ultimately responsible to the shareholders, audit committees should approve the amounts of compensation based on the issuer's individual facts and circumstances and the services received. The new regulations, roles and responsibilities make it imperative that the independent auditor make the full value of the audit more visible to companies and their audit committees and provide an "objective" perspective on issues like business risks, fraud risk, corporate governance and transparency of corporate reporting. Audit fees should be commensurate with the services provided. We believe that the same rationale would apply to the determination of the compensation of advisors engaged by the audit committee.
Application to SROs
We believe that the proposal provides sufficient time for SROs. We believe that timely implementation of these requirements is key to the restoration of investor confidence and public trust.
Application to listed securities
We believe that the exemption is generally appropriate. We agree that the costs of having multiple SROs monitoring the compliance of issuers would outweigh the benefits that may be derived from such monitoring. We also agree with the Commission's focus on common equity or similar securities since those securities most likely represent the primary public listing of the company. We do not believe that the Commission should extend this exception to just any class of securities, as it would not necessarily achieve the adequate level of protection needed for investors.
We further believe that the Commission should permit a similar exception when listed closed-end investment companies and exchange-traded funds are governed by a common board of directors/trustees in an investment company complex but individual funds are listed on different exchanges. Some sponsoring organizations typically either have cross-listed their funds on two or more stock exchanges or have listed certain funds on one exchange, but have listed other virtually identical funds (both in type and governance structure) on another stock exchange. In such a case, without relief the common Board would be required to meet multiple listing standards in the same manner the Commission sought to avoid for other corporate issuers. We believe objective criteria (such as the largest amount of total listed fund net assets by exchange) could be established to enable the Board to identify which listing standards should apply to a particular complex.
We believe that the proposed exemption is adequate.
We believe the exclusion is appropriate.
We do not believe that other securities should be exempted. See our responses to Question 28 above.
Application to issuers
To allow us to comment on the implications of this proposed rule on foreign private issuers, we contacted the leaders of our audit practice in every country that has a client that is registered with the SEC - approximately 50 countries. Their concerns can be summarized into three categories:
Some of our specific comments where there are potential conflicts and problems that will be encountered by foreign private issuers:
a) In many jurisdictions it is not uncommon for most board members to own shares in the company, and some may own more than 10% of the outstanding voting shares. While the rules as proposed would allow one member of the audit committee to be a shareholder, or representative of a shareholder or group, owning more than 50% of the voting securities, many current board members and potential audit committee members may be unwilling to dispose of their holdings. In such a situation, given the already limited pool of audit committee candidates, it may be difficult for companies to find suitable individuals who are willing to serve on audit committees.
b) Audit committees in foreign jurisdictions often have members who are lawyers or advisors and whose firms provide legal or advisory services to the company. These individuals often add significant value to the issuer's audit committee. Given the limited pool of qualified audit committee candidates in some foreign jurisdictions we urge the Commission, in the case of foreign private issuers, to exclude from the definition of compensatory payments remuneration to an entity in which an audit committee member is a partner, member or principal or occupies a similar position and which provides accounting, consulting, legal, investment banking, financial or other advisory services or any similar services to the issuer.
c) While the proposed rules clarify that the shareholders may ultimately elect, approve or ratify the selection of the issuer's auditor if required under a company's governing law or documents, it does not explicitly state that the shareholders may also approve the auditor's compensation. We recommend the Commission clarify whether the shareholders may also approve the auditor's compensation, instead of by the audit committee, if required by the company's governing law or documents.
In all cases in which a foreign private issuer has received an accommodation, we believe they should be required to disclose any variation from the Commission's requirements.
While we are not currently aware of any of our clients considering delisting and deregistering solely as a result of this specific rule proposal, compliance with this rule does increase the cost of being listed /registered in the US market and may prove to be unacceptable for some companies. Several of our non-US clients are taking steps to delist and deregister as a result of the increased cost of compliance associated with the rules being implemented in connection with the Sarbanes-Oxley Act.
We are not aware of any modifications that would be necessary regarding the dual board structure. However, see comments above about lack of time to evaluate the implications globally of this proposed item.
There are a number of situations in which the government of a country is the controlling shareholder and in some instances relating to listed debt securities the sole shareholder. In some situations, the Board of Directors is going to be comprised of individuals that work for the government in some capacity. In some situations members of the Board are appointed by the President of the country and serve at the President's pleasure. These employees could be considered to be affiliated with the issuer and therefore not independent. It is not practicable or appropriate to require the government of a sovereign nation to delegate its responsibility and authority to an audit committee made up of independent directors as a condition to listing in the US. We recommend that the Commission exempt any entity that is directly controlled by a national government from Section 301.
If the Commission does not believe it can provide this broad of an exemption, then it should expand the exemptions from the independence requirements to exempt members that work for the government when the issuer is controlled by the government. Absent granting an exemption, some of these companies may be forced to delist.
As the establishment of audit committees in some countries is a fundamental change in corporate governance and the fact that historically, the Commission has never sought to impose US corporate governance structures on foreign private issuers, some form of accommodations for foreign private issuers is appropriate. However, given the limited time to respond to this proposal, we are unable to properly conclude if such boards of auditors or similar bodies act in a manner similar to an audit committee to warrant this accommodation or, alternatively, if additional accommodations would be appropriate. Accordingly, we believe there should be a sunset provision on this accommodation.
We believe this section of the Commission's proposed rules should contain a two-year sunset provision. We believe the circumstances of each country that wants to be covered by this accommodation should be evaluated to determine if the Board or auditors and other groups operate similar to an audit committee and meets of the spirit of the objectives of the Sarbanes-Oxley Act. We would recommend the AICPA International Practices Task Force and the accounting profession in each country assist the staff in making this assessment. Likewise, it may be determined that there are additional situations in which an exemption is appropriate. At the end of the sunset provision, the Commission would either modify the accommodations based on the information gathered or the exemption would be eliminated in full or in part. We would envision that it would also be possible to expand the accommodations based on particular facts and circumstances. Companies that operate in an environment that would no longer be entitled to any accommodation should have one additional year to establish an audit committee that complies with the requirements of Section 301.
We would like to bring one situation to the Commission's attention. At its May 2001 meeting, the AICPA International Practices Task Force concluded that to comply with the requirements of AU 380 Communication with Audit Committees that the auditor in Japan needed to Report to the Board of Directors in addition to reporting to the Board of Statutory Auditors. However, as noted in the Task Force minutes, this conclusion was based on the existing structure and did not take into consideration any proposed changes in the structure that were being considered by the Japanese Diet.
We would also like to point out that in Note 88 to the proposed rule, the Commission has indicated that effective April 1, 2003, Japanese corporations will have the option to either elect a governance system with a board of directors and board of corporate auditors or a system based on nominating, audit and compensations committees under the Board of Directors. Under this new system, the majority, but not all, of the members are required to be independent. In addition, the definition of independence is different. It would appear that if the Company keeps the current system that they are exempt from the requirements, but if they change to a system that is close to that required in the US that they would lose the exemption. If our understanding is correct, we recommend that the Commission address this fact in the adopting release.
We do not believe that those requirements would impose a disproportionate burden on smaller issuers. We believe that the issues that the Commission is addressing in this proposed rule are pervasive and impact small issuers as well as large issuers. As a result, to respond to the mandate articulated by Congress in the Act, we believe that the proposed rule should equally apply to small business issuers.
See our response to question 35.
Compliance with the proposed standards
We agree with the Commission's requirement to have the listed issuer notify the SRO if the issuer has failed to comply with the proposed requirements. We are also of the view that the word promptly should be defined to ensure consistency of application amongst issuers and timely reporting of non-compliance. We believe that two business days would be an appropriate timeframe for reporting.
It is essential that non-compliance be detected early and corrected in a timely manner. Accordingly, we believe that it would be appropriate to extend the requirement to audit committee members and other directors.
We believe that annual confirmation of compliance to the SROs would be beneficial to investors, with a timely notification of non-compliance provided to the SROs in the interim periods, as contemplated by Question 38.
We are supportive of a full notification to the SRO if an issuer has failed to comply with the listing standards.
Opportunity to cure defects
We believe that each SROs should provide for specific procedures for curing defects and time periods for compliance with the proposed requirements.
We believe that a time limit should be included in the final rule and would suggest a time limit of 30 days.
We believe that the limited exemption provided in the proposed rules for the independence requirements should be sufficient for companies that have just completed their initial public offering. We do not believe that additional time would be necessary for the other requirements.
We believe that the proposed date is appropriate. We believe that timely implementation of these requirements is key to the restoration of investor confidence and public trust.
However, as described above due to considerations unique to foreign private issuers, we believe foreign private issuers should be given at least two years to implement this requirement.
Proposed disclosure changes
Yes, we believe that disclosure of the use of exemptions would be beneficial to investors. Additionally, we believe it would be beneficial to include a disclosure of the company's assessment of whether and if, so, the reliance on those exemptions would materially adversely affect the ability of the audit committee to act independently. We believe it is appropriate to include the disclosure in annual reports.
We support the Commission's efforts to accommodate foreign private issuers with respect to conflicts of law. However, with respect to disclosure, we believe the US investor should know that the company has availed themselves of an accommodation. A conclusion is not being made that the corporate governance structure that is being followed is inferior; rather, the disclosure is simply informing an investor that it is different. The disclosure allows the market to assess the importance of this issue. Absent the disclosure, an investor could improperly assume that the structure is the same as that being followed by other listed companies when that would be factually incorrect.
See our response to question 45.
We believe that the current location for this disclosure is appropriate. We are not aware of any significant practice issues with the current location and do not believe a change is warranted at the present time. We would support disclosure of whether the entire board is acting as audit committee.
Consistent with our response to question 48, we believe that disclosure with respect to all members of the board of directors would be appropriate.
Yes, we believe that they are appropriate.
The Commission has indicted in Securities Act Release No. 8177 that it will require such disclosure. We support the requirement for this disclosure, which can be included in the 20-F. However, we do not believe this information should be required to be disclosed in a Form 40-F. The disclosures required in a 40-F are based on the Canadian requirements and requiring selected disclosure of items is inconsistent with the concept of the multijurisdictional disclosure system.
We believe that all the relevant disclosure requirements, when incorporating our comments noted in this letter, are included in the proposed rule.