November 16, 1999
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609 Audit Committee Disclosure; Release No. 34-41987
Dear Mr. Katz:
Ernst & Young LLP ("Ernst & Young") is pleased to submit our comments on the above-captioned Release. The proposal would implement certain of the recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (the "Committee"), which issued its report and recommendations (the "Report") in February 1999.
The central message of the Report is that audit committees need to be diligent in their oversight of the financial reporting process. To achieve this objective, audit committees need to work closely with management, internal auditors, and independent auditors to promote accurate, high-quality, and timely disclosure of financial and other information to the board, the public markets, and shareholders. The Report includes ten specific recommendations to strengthen the independence of audit committees and to improve their effectiveness. The recommendations required action by the New York Stock Exchange ("NYSE"), the National Association of Securities Dealers ("NASD") for companies listed on the American Stock Exchange ("Amex") or quoted on Nasdaq, the Securities and Exchange Commission ("Commission" or "SEC") and the American Institute of Certified Public Accountants' Auditing Standards Board ("ASB"). As a result, each of these organizations has recently issued rule proposals in response to the Committee's recommendations in a collaborative effort to improve the effectiveness of the audit committee.
We firmly support these efforts and are pleased to comment on the SEC's proposed rules and amendments to its current rules to improve disclosure relating to the functioning of corporate audit committees and to enhance the reliability and credibility of financial statements of public companies.
While we support the rule proposals overall, we believe they could be improved by:
The Report recommended that the audit committee state that, in reliance on the review and discussions with management and the auditors, the audit committee "believes that the company's financial statements are fairly presented in conformity with Generally Accepted Accounting Principles (GAAP) in all material respects." The SEC's rule proposal is an improvement over the Committee's recommendation, which has been met with widespread concern. Holding audit committees responsible for a GAAP conclusion would have extended the audit committee's responsibilities beyond its oversight role and could have made the audit committee more vulnerable to shareholder litigation, notwithstanding the suggested "safe harbor".
The SEC's proposal would instead require that audit committees state whether, based on their review of the audited financial statements and their discussions with management and the independent auditors, "anything has come to the attention of the members of the audit committee that caused the audit committee to believe that the audited financial statements included in the company's Annual Report on Form 10-K for the year then ended contain an untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading." We believe that this proposal does not resolve the concerns about extending the audit committee responsibility beyond its oversight role.
For example, a matter that later turns out to be a financial reporting problem may have been previously discussed with the audit committee albeit in another context and therefore the audit committee could be challenged whether anything came to their attention regarding the matter. Also, audit committee members during the year generally attend many meetings that include discussions and materials on a wide range of subjects. The assertion in the proposed report of the audit committee that no material fact has been omitted from the financial statements could run to all matters discussed and materials distributed to the audit committee even though the discussion did not focus on disclosure or materiality. This appears to be too broad of an assertion to be required of an independent director.
As the SEC noted in its rulemaking release (see text and footnote 61), Ernst & Young sent a letter dated August 20, 1999 to General Counsel Goldschmid and Chief Accountant Turner. In that letter, we suggested, as an alternative to the Committee's recommendation, that the audit committee be required to state their recommendation of approval to the board of directors of the filing of the financial statements in the Form 10-K. An example of such a conclusion in the audit committee report follows:
In reliance on those reviews and discussions, the audit committee recommended to the Board of Directors that the audited financial statements be included with the Annual Report on Form 10-K [or Form 10-KSB] for filing with the SEC.
This type of report better describes the audit committee's oversight role and closely aligns with current practice of audit committees and boards of directors including their signing the Form 10-K or Form 10-KSB. We believe this type of report would promote the type of reflection and diligence by audit committees that the Committee intended. Moreover, in our view this alternative language would create a less significant litigation risk to audit committees. As noted above, audit committee members are exposed to a wide range of information during the course of their service, and the SEC's proposal could make it difficult for an audit committee member to obtain early dismissal of securities fraud allegations that a committee member had access to a material fact that was later omitted from the financial statements.Audit Committee Charters
Audit committee charters are effective tools to clarify the audit committee's responsibilities and presently are utilized by most companies. We believe all companies would benefit from having an audit committee charter.
In addition to a description of the audit committee's authority and responsibilities, charters frequently contain a listing of various matters the audit committee will address during the year. These matters frequently are detailed action steps that go beyond the duties and responsibilities of the audit committee. While such detailed action steps are useful in organizing meetings, they are more detailed than what would normally be considered necessary for a corporate charter. By definition, a charter is a document outlining the principles, functions and organization of a corporate body. However, because of concerns regarding director liability, as well as concerns about the length of the annual proxy statement, registrants might be more inclined to adopt more boiler plate type charters under the proposal. We believe it would be more appropriate to require a summary description of the audit committee's responsibilities and processes in plain English without including the actual audit committee charter in the proxy statement. If published annually, we believe such a summary would be more meaningful to investors than a detailed charter published only once every three years as is provided for in the proposed rule.Disclosure About "Independence" of Audit Committee Members
We concur with the Commission's view that shareholders should know when a member of an audit committee is not independent. The proposed rules have been expanded from the Committee's recommendation to also require proxy statement disclosures for companies whose securities are not listed on the NYSE or Amex or quoted on Nasdaq.
We note that companies whose securities are not listed on the NYSE or Amex or quoted on Nasdaq, including "Small Business" filers, would be required to disclose whether the audit committee members are independent. However, pursuant to the proposed rule, "Small Business" filers whose securities are listed on the NYSE or Amex or quoted on Nasdaq would not have to disclose whether all of their audit committee members are independent. We believe "Small Business" filers listed on the NYSE or Amex or quoted on Nasdaq should be held to the same standard of disclosure as companies not listed or quoted on one of these exchanges, and should disclose whether the audit committee members are independent. We believe investors are entitled to have this information even though having a minority of nonindependent directors on the audit committee is permitted under certain listing requirements.Pre-Filing Review of Quarterly Financial Statements
The proposed rules would require that companies' interim financial statements be reviewed by an independent accountant prior to the filing of a Form 10-Q or Form 10-QSB with the Commission. We question the cost/benefit of requiring timely quarterly reviews for companies with limited market capitalization and trading volume. For example, many companies not subject to Item 302 of Regulation S-K and Regulation S-B filers would have limited market capitalization and trading volume. Historically, the Commission has provided relief for such companies based on the same cost/benefit considerations. Further, requiring timely quarterly reviews for all companies seems in conflict with NASD's proposal to exempt Small Business filers from their new proposed rules related to the number of independent audit committee members and the financial literacy/expertise requirement.
We also note that the Commission is not proposing to require the independent auditor to issue a review report or include such a report in the Form 10-Q or Form 10-QSB. Under current rules, if a company discloses in its filings with the Commission that an independent accountant has performed a review of interim financial statements, it must file a copy of the review report. Since most investors do not understand the limited nature of the procedures performed and may place too much reliance on such reports, we believe the current requirements are appropriate.Applicability to "Foreign Private Issuers"
As stated in the rulemaking release, "The proposals would not apply to `foreign private issuers,' which are exempt from the proxy rules, and which are not required to file Quarterly Reports on Form 10-Q or 10-QSB." Given recent initiatives to improve corporate governance principles and practice worldwide led by the World Bank Group and the Organisation for Economic Cooperation and Development, it is not clear why the proposed rules and related disclosures, other than the pre-filing review of Form 10-Q or Form 10-QSB, would not be required for such non-U.S. companies in Form 20-F, Form 6-K or otherwise. Narrowing the exceptions for non-U.S. companies would help "level the playing field" for U.S. and non-U.S. companies.Effective Dates and Transition
The proposed rule does not specify effective dates for the new requirements. The Commission's final rule should provide explicit guidance to companies regarding the timing for compliance with the various elements of the rule proposal. Based on the issuance date of the final rules, we believe the pre-filing review of quarterly financial statements requirement should be effective no earlier than for the quarter that begins after the effective date of the final rules. Further, the audit committee disclosure requirements should be effective no earlier than for fiscal years ending on or after December 15, 2000 (i.e., disclosures included in proxy statements filed in the Spring of 2001 for calendar year end companies). Using the effective dates suggested above would allow companies and their audit committees adequate time to function under the new rules, including those of the NYSE, NASD or Amex and the ASB, before they are required to make the related disclosures.* * * * *
We would be pleased to discuss our comments with the Commission or its staff at your convenience.
Very truly yours,
/s/ Ernst & Young LLP
Copy to Mr. Harvey J. Goldschmid
Mr. Lynn E. Turner