Squire, Sanders & Dempsey L.L.P.
Counsellors at Law
4900 Key Tower
127 Public Square
Cleveland, Ohio 44114-1304
November 29, 1999
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Audit Committee Disclosure (Release No. 34-41987; File No. S7-22-99)
Dear Mr. Katz:
Squire, Sanders & Dempsey L.L.P. ("Squire Sanders") is pleased to provide the following comments to the Commission's proposed new rules and amendments regarding audit committee disclosure requirements contained in Release No. 34-41987 (the "Proposal"). We agree that the Commission's stated objectives ("to improve disclosure relating to the functioning of corporate audit committees and to enhance the reliability and credibility of financial statements of public companies") continue to be important to a credible financial reporting process. We commend the work of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (the "Blue Ribbon Committee") and firmly support the Commission in its efforts to implement the recommendations of the Blue Ribbon Committee.
Squire Sanders represents a significant number of reporting companies in connection with their periodic reports under The Securities Exchange Act of 1934, as amended (the "'34 Act"). Conversations with some of them have led us to believe that one aspect of the Proposal, if implemented, will be counterproductive. That is the requirement that all reporting companies include in their annual proxy statements an audit committee report containing a negative assurance parroting the language of Rule 10b-5 under the '34 Act. This certification requirement may have a chilling effect on the willingness of qualified individuals to serve as members of audit committees for the reasons stated below.
Separate Class of Directors
We believe the certification requirement is inconsistent with the role that the audit committee is expected to play in the financial reporting process and essentially establishes a separate class of directors. The role of the audit committee, as expressed by the Blue Ribbon Committee and the Commission, is to "facilitate communications between a company's board of directors, its management, and its internal and independent auditors." It is "clearly one of oversight and monitoring." It is the full board, however, "which is the ultimate monitor of the process." In our view, the certification requirement goes far beyond facilitating communication and, instead, establishes the audit committee as the ultimate monitor. The certification requirement imposes a duty upon only SOME directors to represent to investors that they are not aware of any material misstatements or omissions, thereby creating a separate and distinct class of directors responsible for the accuracy of the financial statements (the very same directors who, under the Blue Ribbon Committee's independence proposals, have the least incentive to "cook the books").
As described by the Blue Ribbon Committee, a proper and well-functioning system is a "three-legged stool" consisting of the full board including the audit committee, financial management including the internal auditors, and the outside auditors. We believe the certification requirement establishes the audit committee as a separate and distinct "leg," not intended under the Blue Ribbon Committee's concept.
Increased Potential Liability
We also believe the certification requirement will subject audit committee members to increased exposure to Rule 10b-5 liability under the '34 Act. The Commission recognized the increased exposure to liability that would have resulted from the Blue Ribbon Committee's original recommendation that audit committees certify as to compliance with generally accepted accounting principles. However, we believe the Commission's proposal of a "no material misstatements or omissions" negative assurance by audit committees does not effectively deal with the potential risk of increased liability of audit committee members.
We acknowledge the Commission has followed the Blue Ribbon Committee's recommendation that there be a safe harbor for the audit committee report substantially similar to the safe harbor provided for the report of the compensation committee. The safe harbor does not, however, provide any protection against Rule 10b-5 antifraud liability. Although this also is the case with respect to the safe harbor applicable to the compensation committee report, the lack of protection is far more serious in the context of a representation in the form of the traditional Rule 10b-5 language, unlike anything in the compensation committee report.
As an initial concern, we question whether the Rule 10b-5 language is even appropriate in a financial statement context. Practically speaking, it will be more difficult to apply the concept of "no material misstatements or omissions" to financial statements, as compared to textual descriptions of operational or nonfinancial matters, especially in view of the renewed emphasis on the determination of "materiality" in financial statements as set forth in Staff Accounting Bulletin No. 99.
Of even greater concern, however, is the fact that requiring the specific language in and of itself creates a duty to disclose to which Rule 10b-5 liability exposure attaches. The Proposal states that the Commission does not intend to subject companies or their directors "to increased exposure to liability under the federal securities laws" as a result of the certification requirement. The certification, however, would require the audit committee to make an affirmative representation to investors concerning the accuracy of the company's financial statements. Under the relevant case law, a person must make a false or misleading statement in order to be held liable under Rule 10b-5. In re: JWP Inc. Sec. Lit., 928 F. Supp. 1239, 1255 - 56 (S.D.N.Y. 1996); cf. Mishkin v. Ageloff, 1998 WL 651065 (S.D.N.Y.) (holding that the actual making of a false or misleading statement is not required for Rule 10b-5 liability when the active participation in a fraudulent scheme or commission of a fraudulent act is otherwise involved). Absent the proposed certification (and assuming they have not otherwise participated in fraudulent activity), members of a company's audit committee are not subject to Rule 10b-5 liability for misrepresentations not made by them or for omissions where there was no duty to disclose. See e.g., Central Bank v. First Interstate Bank, 511 U.S. 168 (1994) (holding that there is no private cause of action for "aiding and abetting the fraud" under Rule 10b-5); Shapiro v. Cantor, 123 F.3d 717 (2d Cir. 1997) (holding that in order for accountants to be liable, they must themselves make a false or misleading statement (or omission) that they know or should know will reach potential investors); Bomarko Inc. v. Hemodynamics, 848 F. Supp. 1335 (W.D. Mich. 1993) (members of audit committee were not "controlling persons" subject to liability for the company's misrepresentations under Section 20(a) of the '34 Act since they "played no significant role in the management of the company"). Hence, absent an adequate safe-harbor provision, the affirmative duty to disclose imposed by the certification requirement would appear to result in an increased potential exposure to claims against audit committee members under the federal securities laws.
In summary, we are concerned that the certification requirement may well deter qualified individuals from serving as audit committee members because of a perception of additional exposure--more exposure than board service otherwise involves. We further believe that the perception alone is as important as whether increased potential liability actually exists.
We appreciate this opportunity to provide comments on the Proposal. While we commend the Blue Ribbon Committee and the Commission for their efforts and fully endorse the expressed objectives, we urge the Commission to reconsider the proposed audit committee certification requirement. In our view, merely requiring the audit committee to confirm that it met with management and the independent auditors would motivate the committee to "ask the tough questions," the ultimate goal of the effort underlying the Proposal.
/s/ Mary Ann Jorgenson
Mary Ann Jorgenson
Corporate Practice Area Coordinator
Squire, Sanders & Dempsey L.L.P.