Association of Publicly Traded Companies
1200 G St. N.W., Suite 800
Washington, D.C. 20005
December 6, 1999
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington D.C. 20549-0609
RE: File Numbers SR-Amex-99-38; SR-NASD-99-48; SR-NYSE-99-39; S7-22-99; All Relating to New Requirements for Audit Committees
Dear Mr. Katz:
The Association of Publicly Traded Companies ("the Association" or "APTC") is made up of small cap and mid cap companies, nearly all of which are listed on the Nasdaq, the Amex or the NYSE. We are writing on behalf of the Board of Directors of the Association to comment on proposed changes to the composition and procedures of audit committees contemplated in the four Releases noted above.
INTRODUCTION AND GENERAL COMMENT
The diversity of publicly traded companies in American is a great strength of our economy. Considering the entire spectrum of thousands of public companies, there is no typical corporate board, just as there is no typical business. It is a bedrock principle of the Association that corporate boards and managers, working together in their separate spheres can effectively manage the affairs of each publicly traded company. Corporate boards have broad discretion and solemn responsibilities. Maintaining the board’s flexibility in appointing and tasking audit committees is good corporate governance and promotes accurate financial reporting, one company at a time.
The Association commends the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees ("BRC") for identifying areas in which structural and procedural changes in audit committees might be helpful. Indeed many of the BRC’s recommendations represent practices that some companies have already implemented to improve the quality of their financial reporting. The Association appreciates the BRC’s contribution to the body of knowledge and the overall discourse on corporate governance and financial reporting. We would encourage all publicly traded companies to seriously consider each of the BRC recommendations. However, for the reason stated here, we do not support the new rules and practices embodied in the four Releases.
We think the key to a good audit committee is not more process or more rules. The key to a good audit committee is its membership --directors with character, intelligence and diligence. Reducing the pool of available audit committee members reduces the pool of good ones. Therefore, in net effect, the new requirements will be counterproductive to the goal of better audit committees.
In corporate governance matters, the Association is always alert to new requirements on smaller issuers based on the "best practices" developed by larger issuers.
When the pool of eligible audit committee members shrinks because of inflexible requirements, smaller companies and their shareholders are disadvantaged to a greater degree than large companies. The need to pay more, and search longer, for a good audit committee member who also meets the latest definition of "independence" or "financial literacy" will fall most heavily on the smaller companies who may need them the most.
However, APTC believes it is appropriate to apply whatever changes are required to all companies, regardless of size. All companies are susceptible to manipulation by fraudulent individuals. An investor can lose just as much money from fraudulent financial reporting in a small company as in a large one, and investor confidence is a variable in the cost of capital. Therefore, the Association does not advocate a second tier of audit committee requirements based on company size. If a new practice or requirement is universally helpful in preventing fraud, it should apply to all public companies. On the other hand, if a new structural or procedural requirement is largely cosmetic or, would be counterproductive to good audit oversight, a minimal cost burden should not matter.
Finally, the Association rejects the notion that the Securities Exchange Commission should use its influence over listing standards, or its power to compel disclosure as tools to change corporate behavior. The boards of companies, not the government, should determine which BRC-recommended changes to adopt in discussion with managers, shareholders and their outside consultants. However, we recognize that most of these proposals will be adopted. Therefore, we offer some proposed modifications that may lessen their immediate negative impact.
Increased Risk Of Liability Will Be The Main Negative Impact
The Association is particularly concerned with new requirements that increase liability, increase the risk of additional liability, or even increase the mere perception thereof. It is no comfort that a company can win in court. The fact of being sued for fraud or misfeasance is deterrent enough to board or audit committee service. Our interest in the proposed SEC-mandated audit committee affirmation and audit committee qualifications are, therefore, most acute.
Most of the new mandatory disclosure in the proposed audit committee report will only create more verbiage in proxy statements and annual reports, documents already overburdened with mandated, standard phraseology. Legalese in mandated reporting only serves to obfuscate rather than clarify. Therefore, the Association opposes this new audit committee report in general.
However, we believe that the portion of the audit committee report dealing with the content of the audited financial reports will cause serious problems for companies attempting to staff audit committees. While the proposed language in the Release is an improvement over the Blue Ribbon Committee’s "GAAP certification" language, it will still raise liability concerns.
Recent legislation addressing abusive securities class action suits has, unfortunately, not diminished the number of suits. Indeed they have increased. According to the Stanford Securities Class Action Clearinghouse, 526 companies have been sued since enactment of the Private Securities Litigation Reform Act in December 1995. Two hundred thirty-five companies, a new record, were sued in 1998 alone. While the typical pre-1995 complaint alleged "fraud-by-hindsight" based on projections, these suits now focus on financial reporting. The Stanford Clearinghouse reports that more than half of recent cases allege "accounting fraud."
The following excerpt from a November 23, 1999 press release announcing the filing of a securities class action lawsuit is instructive.
"The securities class action complaint charges the defendants with
violations of the federal securities laws …by, among other things, misrepresenting and/or omitting material information concerning the Company's net earnings. The complaint further charges that these misrepresentations were the result of the combined defendants actions in…creating false billings for advertising and fixed asset costs to its vendors, understating its cost of sales through acquisition accounting, capitalizing inventory costs that should have been recorded as expenses, overstating inventory by failing to account for missing or obsolete inventory, and creating fictitious postings to both the inventory and expense accounts." [Emphasis supplied, citation omitted.]
Audit committee members could be defendants or prominent witnesses in this sample litigation. However, had the audit committee stated that it believed the financial reports were accurate, that statement could be central to an allegation of fraud. Furthermore, had the company indicated that its audit committee members had certain attributes of financial acumen, the actual financial acumen of each audit committee member would be a question of fact relevant to the intent of the company’s board.
APTC members have been targets of securities strike suits. This experience breeds caution toward ambiguous rules, the violation of which plaintiffs’ lawyers can point to as evidence of "fraud." These new disclosures and qualifications will cause potential audit committee members to ask whether they should expose themselves and their personal assets to such liability.
APTC Recommendation No. 1
APTC, therefore, recommends that these new requirements be reviewed more extensively before any implementing decision is reached. As a second recommendation, assuming the Commission moves rapidly forward with these new requirements, APTC recommends that the various "alternative formulations" cited or discussed in the Release be approved as permissible alternatives. If the SEC believes that each formulation would accomplish the Commission’s purpose, why not allow the audit committee to "pick its poison?"
"Universal Financial Literacy" Will Eliminate Some Good Audit Committee Members
In addition to liability concerns, we oppose the financial literacy requirement because it could deprive the audit committee of the service of an individual with exceptional character and/or operational experience that might otherwise not be present on the committee. In this context, it is important to make a larger point and distinguish between the roles of the auditors and the audit committee. The ability of an audit committee to exercise its proper, limited oversight role depends far less on the financial training or "literacy" of all its members than on the commitment of the committee to inquire into the auditor’s methods and conclusions. A person with a thorough understanding of a business brings a useful perspective to overseeing the auditors. In the same vein, a person who simply will persist in searching for "plain English" answers offers a valuable perspective.
Moreover, a focus on each individual member of the audit committee distorts the basic idea of a committee. Committees act collectively. Their authority is based on collective work. It is the collective financial literacy of the entire committee that matters.
APTC Recommendation No. 2
Therefore, we recommend that the proposed requirements regarding individual financial acumen be replaced with a requirement that the collective financial acumen of the committee meet a required standard. This will allow boards to retain some discretion in appointing audit committees. It may also reduce the importance of every single audit member’s ability to withstand cross-examination by class action plaintiffs’ lawyers.
The Independence of Audit Committee Members is a Proper Board Determination
APTC Recommendation No. 3
APTC supports the requirement that audit committees be made up of independent members provided that "independence" is an individual determination at the discretion of the Board. Once again, an individual’s "independence" should be based on whether the individual would place the interests of the corporation and its shareholders above any other. The integrity and the objectivity of the individual mean more than any relationship. The board is in the best position to make these individual determinations.
We encourage the Commission to further deliberate and study the overall consequences of these new requirements. Furthermore, we ask that the Commission to consider the intermediate step of recommending these new practices to issuers rather than jumping preemptively from recommendation to rule.
If the Commission chooses to move forward with these proposals, we reiterate our abiding concerns with litigation exposure and its effect on the willingness of good members to serve on audit committees. In this key area we recommends two changes. First, if audit committees must make a statement regarding the audited annual financial statements, the committee should have discretion in terms of the language it uses. Second, we recommend a shift away from "financial literacy" rules for individual audit committee members toward a focus on the committee’s collective financial acumen, reflecting the collective nature of the audit committee’s purpose and authority.
Finally, APTC opposes rigid relationship-based determinations of "independence" for audit committee members. We believe that boards can make a more effective determination on the overall independence of it members.
For the Board,*
Robert S. Merritt/s/ Brian T. Borders/s/
* John C. Kikol, an APTC Board member who also served on the Nasdaq Subcommittee to Consider the Blue Ribbon Committee Report, support the Nasdaq listing standard as proposed and respectfully dissents from the APTC views as they relate thereto.