December 10, 1999
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Exchange Act Release No. 41987
File No. S7-22-99
Attention: Jonathan G. Katz, Secretary
Ladies and Gentlemen:
We are writing on behalf of the Committee on Securities Regulation of the Association of the Bar of the City of New York in response to Release No. 34-41987, dated October 8, 1999 (the "Proposing Release"), in which the Securities and Exchange Commission (the "Commission") requests comments on proposed requirements for disclosure about audit committees and a proposal to require that independent auditors review the unaudited financial statements that are included in quarterly reports filed with the Commission. Our Committee is composed of lawyers with diverse perspectives on securities issues, including members of law firms, counsel to both corporations and investors, academics and members of the judiciary. A list of our Committee members is attached.
Table of Contents
II. Pre-Filing Review of Quarterly Financial Statements
III. The Audit Committee Report
IV. Other Disclosure in Proxy Statements About Audit Committees
V. Proposed Safe Harbors
We support the goals of improving financial reporting evidenced by the Commission's proposals.
The Commission's proposals are intended to implement certain recommendations made by the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (the "Blue Ribbon Committee") in its 1999 Report and Recommendations ("Blue Ribbon Committee Report"). The Blue Ribbon Committee Report addressed what we believe to be legitimate concerns about how audit committees function and the impact of these concerns on confidence in financial reporting. We believe that loss of confidence in financial reporting would have a negative impact on our financial markets.
We believe it is appropriate for the Commission to address these concerns; we commend the Commission for doing so, and we support the Commission's policy objectives, even though we do not agree with all aspects of the proposals.
II. PRE-FILING REVIEW OF QUARTERLY FINANCIAL STATEMENTS
The Commission proposes to require that interim unaudited financial statements that are included in Quarterly Reports on Forms 10-Q and 10-QSB be reviewed by independent auditors in accordance with Statement on Auditing Standards No. 71, "as may be modified or supplemented by the Commission," prior to filing with the Commission. (Proposed Rule 10-01(d) of Regulation S-X; proposed Item 310(b) of Regulation S-B.) The Commission asks whether this requirement also should apply to interim unaudited financial statements included in registration statements filed under the Securities Act or the Exchange Act. (We note that the proposed requirement would apply to quarterly reports incorporated by reference in Securities Act registration statements.)
We support the Commission's policy goals in making this proposal, although we believe there may be some question as to the Commission's authority to require review of interim unaudited financial statements or to modify or supplement generally accepted auditing standards ("GAAS").1 Alternatively, we suggest that the national securities exchanges and the Nasdaqcould require such reviews of the interim financial statements of issuers that have securities listed or admitted to quotation on those markets.
We believe that for larger companies interim reviews may be relatively inexpensive and have the potential to lower overall audit fees. We also believe that these interim reviews could be a useful tool in avoiding the "earnings management" issues that are of such concern to the Commission. However, we do not believe that the independent auditor's review should be required to be completed prior to a company's preliminary earnings release.
Requiring the interim review to be completed prior to "earnings releases" is not in the shareholders'/investors' best interest. Requiring such prior review would simply delay the release of important financial information to shareholders and potential investors. Most companies are already sufficiently motivated by the analyst and investor community to be confident that the results in their earnings releases will be reflected in their quarterly financial statements. It would be unduly burdensome to require that the interim review be completed prior to earnings releases.
We also note that those companies whose financial statements are audited by the "Big Five" accounting firms generally will be required to undergo review of their interim financial statements as a condition of their engagements. Moreover, underwriters of securities registered under the Securities Act offered to the public often require review by independent auditors of any interim financial statements included in the registration statement. In addition, underwriters invariably require "negative assurance" from the independent auditors as to these financialstatements.2 If the Commission should conclude that it has the authority to adopt the proposal,3 we would support applying the review requirement to interim unaudited statements included in Securities Act registration statements.4
If the Commission should conclude that it does not have the authority to require review of interim reports by independent accountants, we believe the national stock exchanges and Nasdaq could adopt similar requirements as conditions to listing.
We have considered the issue as to whether the proposal should apply to smaller issuers. On balance, due to the significant incidence of financial reporting problems experienced by smaller issuers,5 we believe they should.
III. THE AUDIT COMMITTEE REPORT
The Commission has proposed that a report of the audit committee be included in proxy statements relating to meetings at which directors are to be elected. (Proposed Item 306 of Regulations S-K and S-B) The report would be required to state whether:
1. the audit committee has reviewed and discussed the audited financial statements in the company's latest Annual Report on Form 10-K or 10-KSB with management;
2. the audit committee has discussed with the independent auditors the matters required to be discussed by Statement on Auditing Standards No. 61 ("SAS 61");
3. the audit committee has received the written disclosures from the company's independent auditor required by the Independence Standards Board Standard No. 1 and has discussed with the independent auditor the independent auditor's independence; and
4. based on the review and discussions referred to in 1 through 3 above, 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 or Form 10-QSB for the year then ended contain any 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 agree that the audit committee has a responsibility to discuss the audited financial statements with management and the independent auditors and to ask questions designed to assure the quality of the issuer's financial reporting and audit process. However, since SAS 61 is a professional standard directed at the independent auditors, the determination of what matters must be discussed in order to comply with that standard is a professional judgment that necessarily must be made by the auditors rather than the audit committee. Accordingly, the Commission should not require the audit committee to confirm that it has discussed "the matters required by SAS 61".
If the Commission determines that a reference to SAS 61 is a useful means of focusing the desired discussion, we would propose that item (2) be rephrased as follows:
(2) The audit committee also has reviewed and discussed the audited financial statements with the independent auditors. In connection with those discussions, the members of the audit committee have requested the auditors to identify the matters that should be communicated to the audit committee pursuant to SAS 61 and the members of the audit committee have considered and discussed those matters with the auditors.
We understand that the Commission substantially revised item (4) of the proposed audit committee report in light of concerns, which we share, that had been expressed relating to the audit committee "certification" proposed by the Blue Ribbon Committee proposal. However, webelieve that the revised formulation suffers from a similar flaw, in that audit committee members cannot be expected to have sufficient detailed knowledge to reach the conclusion required by this item. While we agree with the Commission that the audit committee plays an important role in promoting reliable and transparent financial reporting, that role is one of oversight, not day-to-day management. A determination that particular financial statements contain no material misstatements or omissions would require a level of detailed knowledge of each financial statement line item that even the most expert and diligent audit committee member could not, and should not, be expected to achieve.
In addition, assuming a well-functioning financial reporting and governance process (the presence of which is confirmed in items (1) through (3) of the proposed audit committee report), an additional certification by the audit committee regarding financial statement contents would add little of value to the audit opinion already required with respect to those financial statements. Requiring such a specific statement from the audit committee would also be inconsistent with established standards of due diligence imbedded in the Federal securities laws, which expressly permit and encourage reliance upon experts to certify information within their particular areas of expertise.
The Commission has stated that proposed Item (4) is not overly burdensome because it permits the audit committee to rely upon advice and discussions with management (an assertion that we note could have applied to the original Blue Ribbon Committee proposal rejected by the Commission). However, to the extent the conclusion required in item (4) is derived merely from expert advice, item (4) adds little of substance to items (1) and (2) of the proposed audit committee report. More importantly, we disagree with the Commission's premise that the advice that would be received by the audit committee would provide a basis for the conclusion required by proposed item (4). While accounting professionals are well qualified to provide information to the audit committee bearing on whether an issuer's financial statements comply with GAAP, it is debatable whether such compliance is synonymous with, or more or less exacting than, the standard in proposed item (4). Moreover, the standard traditionally applied to assess the adequacy of financial statements contained in a Commission filing is GAAP, not the antifraud standard proposed here, which is a legal standard generally applied to assess the adequacy of the filing as a whole, rather than the financial statements portions of the filings.6
However, in support of the Commission's goals, we would support a requirement that the audit committee report contain the items (1) through (3) above, but that, in lieu of item (4) as described above, the audit committee report would state:
(4) based on the review and discussions referred to in (1) through (3) above, the audit committee had recommended to the full board of directors that the audited financial statements be included in the Form 10-K or Form QSB.7
We would support this approach because we believe it more properly strikes the balance between the Commission's goal of encouraging active involvement by the audit committee in the financial reporting process and the committee's traditional oversight role.
The Commission has requested comment as to whether more complete disclosure regarding the committee's deliberations would be desirable. We believe that the currently proposed audit committee report, modified as proposed above, would sufficiently reinforce the audit committee's responsibilities to promote reliable financial reporting and would be preferable to more detailed disclosures of audit committee deliberations.
Unlike compensation decisions, which are almost purely a matter of discretion, accounting disclosures are grounded on well-developed principles and procedures set forth in the accounting literature, (i.e., GAAP and GAAS). Accordingly, in order to make the confirmations currently proposed in items (1) through (4), the audit committee must consider the particular accounting issues that necessarily arise when those established principles and procedures are applied to the issuer's particular business activities.
Because the relevant accounting issues must be addressed by the committee, whether or not public disclosure is required, we believe that additional detailed disclosure will be of limited benefit. Further, we believe that any such benefit would be far outweighed by the costs. Detailed disclosure would require the diversion of valuable committee resources otherwise available for oversight functions to prepare the report and resolve questions as to its accuracy, adequacy and level of detail.
We also believe that disclosure of the details of a board committee's deliberations would invite second-guessing by outsiders and would be inconsistent with the deference embodied in the business judgment rule.
Subject to the clarification we suggest in Section V.A of this letter (State Corporate Law), we agree with the Commission that individual signatures by the audit committee members are not necessary and that it is sufficient to require that the report be issued over the names of the members, as the compensation committee report is currently issued.8 However, we note that our support for the requirement for naming the individual committee members is contingent upon the adoption of the safe harbors provisions suggested by us below.
The Commission has requested comment as to whether the audit committee report should be included in the issuer's proxy statement, annual report to stockholders or Form 10-K. As noted above, the deliberations confirmed in the report must occur during the year-end audit process, regardless of where or when the report is ultimately printed. Accordingly, we believe that inclusion of the report in any of the proposed filings, as the company's option, is acceptable, so long as the safe harbor protections that we propose below would apply equally regardless of the choice of filing. We believe that the company must have the option as to whether to include the report and any amendments thereto in its Annual Report on Form 10-K or in its Proxy Statement due to the difference between the timing of annual meetings and the filing of Annual Reports on Form 10-K and Form 10-QSB.
In response to the Commission's question regarding issuers not subject to the proxy rules, we believe that reliable financial reporting is equally important to investors in the securities of those issuers. Accordingly, if the current proposal to include the audit committee report in the proxy statement is adopted for companies subject to the proxy rules, we would propose an alternative requirement for issuers not subject to those rules to include a comparable report in the Annual Report on Form 10-K. To the extent the particular issuer is not required to maintain anaudit committee, we would support the proposal to impose this reporting requirement on the Board of Directors as a whole.
The Commission also has proposed liability "safe harbors" covering the audit committee report. (Our comments on these safe harbors appears under "PROPOSED SAFE HARBORS" below.)
IV. OTHER DISCLOSURE IN PROXY STATEMENTS ABOUT AUDIT COMMITTEES
The Commission proposes to add Item 7(e)(3) to Schedule 14A to require other disclosure about audit committees, their members and their charters. The proposed item would require a company, if it has an audit committee, to disclose:
1. the information required by Item 306 of Regulation S-K. (Presumably, under the instructions to Schedule 14A, small business issuers would refer to the provisions of the corresponding item of Regulation S-B, which is substantially identical to that in Regulation S-K.);
2. whether the audit committee has a written charter; and
3. certain information about members of the audit committee who are not independent under the standards of the NYSE, AMEX or Nasdaq, whichever are applicable.
Companies that are not subject to the audit committee member independence standards of the NYSE, AMEX or Nasdaq would be required to disclose whether the members of their audit committees are independent under the standards of one of those self regulatory organizations. The company could choose which of the SROs' standards it uses for this comparison.
The Commission has proposed liability "safe harbors" identical to those that would be applicable to the disclosures in the audit committee report that would be required by Item 306 of Regulations S-K and S-B.
We have no objection to these proposals as they apply to companies with securities listed on the NYSE or the AMEX or admitted to NASDAQ. As to companies that do not have securities listed on these stock exchanges or admitted to NASDAQ, we believe that the Commission's proposal is appropriate.
V. PROPOSED SAFE HARBORS
The Commission has indicated, in Section III.E of the Proposing Release, that they "do not intend to subject companies or their directors to increased exposure to liability under the Federal securities laws, or to create new standards for directors to fulfill their duties under state corporation law." In addition, the Commission believes that "[t]o the extent that the proposed disclosure requirements would result in more clearly defined procedures for, and disclosure of, the operation of the audit committee, liability claims alleging breach of fiduciary duties under state law actually may be reduced."
Although the Commission does not believe that the proposed disclosure requirements would result in increased liability, the Commission determined to follow the recommendations of the Blue Ribbon Committee and propose liability safe harbors to cover the new required disclosure. Without effective safe harbors, qualified directors may be hesitant or unwilling to serve on a company audit committee due to increased exposure to liability.
For the reasons discussed below, we do not believe that the liability safe harbors proposed by the Commission would be effective. However, we would support, in principle, an alternative which essentially would follow the approach taken in the Litigation Reform Act and require proof of intentional conduct to establish a violation of the Federal securities laws, based on the report of the audit committee.
The liability safe harbors, in proposed Items 306(c) of Regulations S-K and S-B and proposed Item 7(e)(3)(v) of Regulation 14A, would track the safe harbor for compensation committee reports provided by Item 402 of Regulation S-K. Unless a company specifically requests that it be treated as soliciting material or specifically incorporates the information in a document filed under the Securities Act or the Exchange Act, the required disclosure would not be considered "soliciting material" "filed" with the Commission or subject to Regulation 14A or 14C or to the liability provisions of Section 18 of the Exchange Act.
The Commission requests comments as to whether it should adopt the proposed safe harbors and whether any safe harbor is necessary. The Commission also requests comments as to whether the safe harbors should apply to all or only certain of the new required disclosures and whether the scope of the proposed safe harbors is appropriate.
We believe that the safe harbors are necessary to cover both Items 306 (a)(1) through (3) of Regulations S-K and S-B and Item 7 (e)(3) of Schedule 14A, in addition to Item 306(a)(4) of Regulations S-K and S-B. Notwithstanding that those items address historical facts, we believe that they should be covered by the safe harbor to avoid unwarranted litigation and, therefore, theCommission should adopt the safe harbor with respect to those items. Except as discussed below, we believe that the scope of the safe harbors is appropriate for these purposes.9
As indicated by our comments on the audit committee report, we are opposed to a requirement for the audit committee to state whether, based on its discussions with the company's management and independent auditors, anything has come to the attention of the members of the audit committee that caused the audit committee 10 to believe that the audited financial statements included in the company's annual report on Form 10-K or 10-KSB for the year then ended contain an untrue statement of 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.
Our opposition to this proposal is based, in part, on the lack of effective safe harbors for these statements. However, should the Commission determine to adopt this requirement, we believe that some forms of meaningful safe harbors covering this item will be necessary to protect audit committee members from vexatious litigation. As discussed above, we would support, in principle, the safe harbor modeled on the approach in the Litigation Reform Act.
We believe the safe harbors proposed by the Commission are inadequate because, among other things:
1. they do not, and cannot, preempt state corporation laws providing for actions for breach of the fiduciary duty of care or the duty of candor in disclosure;
2. they do not, and cannot, preempt certain state securities laws;11
3. they do not address Commission administrative actions under Section 21C of the Exchange Act or the degree of culpability the Commission must find to establish that someone was a cause of a violation of Item 306 (a)(4);4. it is unclear whether a member of an audit committee who previously had been a practising certified public accountant would be subject to proceedings under Rule 102(e); 5. the unsettled state of the law as to what degree of reckless conduct is sufficient to support a finding of scienter in actions brought under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder and, how recklessness is required to be pled and proved;12 and
6. the uncertainty as to whether requiring the names of the members of the audit committee to appear below the report might constitute "signatures," in light of the Commission's position that a person who signs reports filed with the Commission, assuming they act with scienter, are primary violators of the Federalsecurities laws, even if they did not participate in the preparation of the report.13
A. State Corporation Law.
State corporation laws recognize causes of action for violation of the fiduciary duty of care. State corporate laws also may recognize causes of action for violation of the duty of candor in disclosure by directors to their company's stockholders and the public.14
The Commission stated in the Proposing Release that "the more informed the audit committee becomes through its discussion with management and the auditors, the more likely that the `business judgment rule' will apply and provide broad protection."15 However, we believe the business judgment rule may not cover violations of the duty of care or the duty of candor in disclosure, as applied to statements by directors to stockholders or the public.16
Although the required audit committee report would be made in connection with requests of stockholders to act, at least with respect to the election of directors, if the stockholders canprove that they were damaged, requests for stockholder actions may not be needed to support a cause of action for violation of the duty of candor in disclosure.17
We recognize that, even if the business judgment rule is not available, the members of the audit committee, in performance of their duties, may be able to assert other defenses to state law causes of action.18
Directors may be able to assert good faith reliance on records of the corporation and information, opinions, reports or statements by officers, employees and committees of the board of directors or other persons, including independent auditors, if reasonably believed to be within the other person's professional or expert competence and such person has been selected with reasonable care by or on behalf of the company, as protection against claims under state corporation laws.19 However, directors may be required to act in good faith with due care, after reasonable inquiry, if the circumstances warrant, to rely on statements of management or others.20
In some states, directors may be protected by provisions permitting elimination of personal monetary liability of directors for good faith actions involving breaches of fiduciary duty that do not involve breaches of the duty of loyalty, intentional misconduct involving violation of law, or certain other actions.21
Corporations also may be able to indemnify directors if they acted in good faith and in a manner they reasonably believed was in the best interest of the corporation.22
Notwithstanding these protections, and particularly given the uncertainty that may develop, we are concerned that imaginative plaintiffs' counsel may be able to plead state law causes of action for misleading statements made pursuant to Item 306(a)(4) that may survive motions to dismiss or for removal and dismissal under Section 28(f).23 This could result in expensive discovery practice and incentives to settle these actions to avoid the expense of litigation. The alternative safe harbor we suggest above would alleviate many of those concerns.
B. State Blue Sky Laws.
Section 28(f)(4) of the Exchange Act preserves the jurisdiction of state securities agencies to investigate and bring enforcement actions.
C. Cease-and-Desist Proceedings.
Section 21C of the Exchange Act authorizes the Commission to enter cease-and-desist orders against any person who has violated or caused a violation of that Act due to an act or omission the person knew or should have known would contribute to such a violation. TheProposing Release is silent as to whether the liability safe harbor rules would protect against those proceedings and we assume that the Commission's position is that they would not. This is troublesome, since it would permit the Commission to institute cease-and-desist proceedings against audit committee members who the Commission alleges "should have known" that their report concerning the audited financial statements was in violation of the provisions of the Exchange Act. Moreover, the Commission has not indicated what state of mind it would have to prove to establish a violation of Proposed Rule 306(a)(4).24
D. Rule 102(e) Proceedings.
The Commission has asserted the right to institute Rule 102(e) proceedings against financial officers who were, but no longer are, licensed CPAs, based on allegations of improper "professional conduct". See, e.g., Administrative Proceeding No. 3-9793, Securities Exchange Act of 1934 Release No. 41812 (August 31, 1999).
The NYSE, the AMEX and the NASD have proposed that, as a condition to listing or, in the case of the NASD, inclusion in Nasdaq, companies will be required to have independent audit committees of at least three members, at least one of whom must have had past employment experience in finance or accounting, requisite professional certification in accounting or other comparable experience. See Exchange Act Release Nos. 41980, 41981 and 41982 (October 6, 1999). Should these proposals be adopted and should the Commission continue to adhere to its position that it may institute Rule 102(e) proceedings against persons who are no longer acting as CPAs, former CPAs could be discouraged from serving on audit committees of companies subject to the rules of the NYSE, AMEX or the NASD, since the safe harbors would not protect them from Rule 102(e) proceedings.
E. Actions Based on Allegations of Reckless Behavior.
The safe harbor would not protect audit committee members against allegations that they violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder by acting recklessly in stating that nothing has come to their attention that caused them to believe that the audited financial statements included in the Company's annual report on Form10-K or Form 10-KSB for the year then ended contained an untrue statement of a material fact or omitted to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading. This creates an unacceptable degree of uncertainty, since the Federal appellate courts have split on the issue as to what degree of reckless conduct would support a finding of scienter and, if so, what conduct constitutes recklessness and how recklessness shouldbe pled for purposes of Rule 10b-5 actions25 and the Supreme Court has declined to address the issue.26 We believe that the safe harbor suggested above would alleviate some of these concerns.
F. Signature Issues.
Item 306(b) of Regulations S-K and S-B require that the printed name of each member of the Company's audit committee (or the board of directors in the absence of an audit committee) must appear below the disclosure required by Item 306(a) of those regulations.
The Commission has not proposed that the members of the audit committee provide their individual signatures to their report. However, in Section III.E of the Proposing Release, the Commission's discussion of the requirement for printing the names of the audit committee members immediately below their report follows immediately after a discussion of the Commission's view that "by signing documents filed with the Commission, board members implicitly indicate that they believe that the filing is accurate and complete." In view of that discussion and the reference in accompanying footnote 59 concerning the Commission's brief amicus curiae in Howard v. Everex, supra note 13, we believe that, to avoid uncertainty, if the Commission adopts proposed Rule 306(a)(4) and 306(b), it should expressly provide in Rule 306(b) that printing the names of the audit committee members immediately below their report, for liability purposes, is not the equivalent of the audit committee members individually signing the report.
We believe that if the Commission's proposals are adopted, the effective date of the reporting requirements should be in 2001 to allow ample time for boards of directors and audit committees to consider the need to reconstitute their audit committees and to adopt or consider revisions to the charters of their audit committees.
Members of our Committee would be pleased to meet with members of the Staff of the Commission to discuss the comments in this letter.
/s/ Stephen J. Schulte
Stephen J. Schulte,
Chair Committee on Securities Regulation
/s/ Richard H. Rowe
Richard H. Rowe,
Chair of the Drafting Task Force
Drafting Task Force:
Richard H. Rowe, Chair
Peter C. Clapman
James B. McHugh
Ernest T. Patrikis
Neila B. Radin
cc: The Honorable Arthur Levitt, Chairman
The Honorable Paul R. Carey, Commissioner
The Honorable Isaac C. Hunt, Commissioner
The Honorable Laura S. Unger, Commissioner
The Honorable Norman S. Johnson, Commissioner
David B.H. Martin, Director Designate, Division of Corporation Finance
Michael R. McAlevey, Deputy Director, Division of Corporation Finance
1 We note that, although Section 13(b)(1) of the Exchange Act provides the Commission with authority to prescribe the form, details and methods used in preparing reports filed with it, Section 13(a)(2) of the Exchange Act provides that the Commission may adopt rules to require "[such annual reports ... certified if required by the rules and regulations of the Commission by independent accountants, and such quarterly reports ... as the Commission may prescribe." Thereis no reference in the Exchange Act to authority to require the independent auditors to review these quarterly reports. We further note that the Commission's only express authority to modify or supplement GAAS is found in Section 10A of the Exchange Act. That Section applies only to audited financial statements.
2 In addition, the audited financial statements of issuers subject to Item 302 of Regulation S-K are required to include specified interim financial information in a footnote. Under SAS No. 71, if the auditor has not reviewed that information under the standards in SAS No. 71, the auditor must modify its report on the audited financial statements. In our experience such modified reports are rare.
3 Schedule A of the Securities Act, paragraphs (25) and (26), which permit the Commission to require financial statements "certified" by independent public accountants, apply to annual financial statements.
4 We note that interim financial statements included in Forms 10-Q and 10-QSB incorporated by reference in Securities Act registration statements would be reviewed, in any event, should the Commission adopt the proposal.
5 See, e.g., Fraudulent Financial Reporting 1987-1997, An Analysis of U.S. Public Companies, Research Sponsored by the Committee of Sponsoring Organizations of the Treadway Commission (March 1999).
6 Cf. U.S. v. Simon, 425 F.2d 796 (2d Cir. 1969).
7 The Commission requested comments on another alternative. That alternative would have required the audit committee to state whether, based on its discussions with management and the independent auditors, it was aware of any material modifications that should be made to the financial statements. We believe that our suggested alternative is preferable. We note that an approach similar to that which we suggest was suggested in Exhibit 1 to a letter, dated August 20, 1999, from Thomas L. Milan, Partner, Ernst & Young LLP, to Harvey J. Goldschmid, General Counsel, and Lynn E. Turner, Chief Accountant. See Proposing Release footnote 61 and accompanying text.
8 See Item 402(k) of Regulation S-K.
9 We note that the safe harbors for forward looking statements in Section 27A of the Securities Act and Section 21E of the Exchange Act and Rule 175 and Rule 3b-6 do not apply to statements of historical fact.
10 It is not clear, as drafted, whether this proposal is intended to apply to the members of the audit committee collectively, individually or both. If something came to the attention of a member of the audit committee which caused or should have caused that member to believe the audited financial statements contained an untrue statement of material fact, but that member negligently failed to bring it to the attention of the other members, is the report of the audit committee misleading? The Commission should revise this rule to make it clear that no member of the audit committee is responsible for the knowledge of another member of the Committee or for action or non-action taken independently by another committee member.
11 Section 28(f)(4) of the Exchange Act preserves the authority of state securities authorities to bring actions under state Blue Sky laws.
12 The safe harbors would not protect statements actionable under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
13 See Brief for the Securities and Exchange Commission, Amicus Curiae, Howard v. Everex Systems, Inc. (9th Cir. 1999) (No. 98-17324).
14 See, e.g., Emerald Partners v. Berlin, 726 A.2d 1215 (Del. 1998); Malone v. Brincat, 722 A.2d 5 (Del. 1998); Lewis v. Vogelstein, 699 A.2d 327 (Del.Ch. 1997); Arnold v. Society for Savings Bancorp, Inc., 650 A.2d 1270 (Del. 1994); Lynch v. Vickers Energy Corp., 383 A.2D 278, 279 (Del. 1978).
15 Citing American Law Institute, Principles of Corporate Governance: Analysis and Recommendations 134-98 (1994); In re Caremark Int'l Derivative Litig., 698 A.2d 959, 967-970 (Del. Ch. 1996).
16 See, e.g., Emerald Partners v. Berlin, 726 A.2d (Del. 1998) (directors must exercise due care when communicating with the public or with stockholders).
17 See, e.g., Malone v. Brincat, 722 A.2d 5 (Del. 1998); Lewis v. Vogelstein, 699 A.2d 327, 330 (Del. Ch. 1997).
18 Section 28(f) of the Exchange Act may provide some protection, in that, under that Section, "class actions" alleging material misstatements or omissions or the use of manipulative or deceptive devices in connection with the purchase or sale of securities covered by the Section in violation of state law may not be maintained. However, Section 28(f) does not apply to state class or derivative actions alleging breaches of fiduciary duty. See, e.g., Lalondriz v. USA Networks Inc., [1999 Transfer Binder] Fed. Sec. L. Rep. (C.C.H.) ¶ 90, 519 (S.D.N.Y. 1999), on reconsideration, remand stands, (S.D.N.Y. September 24, 1999); Malone v. Brincat, 722 A.2d 5, 13 (Del. 1998).
19 See, e.g., Delaware General Corporation Law (DGCL) § 141(e); California Corp. Code § 309(b). All 50 states and the District of Columbia provide protection for directors who rely on reports of independent auditors. See e.g., § 309 of the California Corporation Code; 141 (e) of the DGCL
20 See, e.g., California Corporation Code § 309(b); Gaillard v. Natomas Company, 208 Cal. App. 1250, 256 Cal. Reptr. 702 (1989) (compensation committee members should have made further inquiry; could not reasonably rely on statements of counsel).
21 See, e.g., DGCL §102(b)(7); Arnold v. Society for Savings Bancorp, Inc., 650 A.2d 1270 (Del. 1994) (breaches of duty of candor in disclosure protected by DGCL §102(b)(7)).
22 See, e.g., DGCL §145.
23 See, e.g., Knorp, Jr. v. Smurthwaite, No. 50760760 (CA 1999) (refusal to apply Delaware business judgment rule and law limiting discovery in action against Delaware corporation).
24 Cf. Checkosky v. SEC, 139 F.2d 221 (D.C. Cir. 1998).
25 See, e.g., Sunstrand v. Sun Chem. Corp. (7th Cir. 1977); Williams v. WMX Technologies Inc., 112 F.3d 175, 177-78 (5th Cir. 1977); Press v. Chemical Inv. Servs. Corp., 166 F.3d 529 (2d. Cir. 1999); In re Advanta Corp. Sec. Littig., 180 F.3d 525, 534 (3d Cir. 1999); In re Silicon Graphics Inc. Sec. Littig., 183 F.3d 970, rehearing denied (October 27, 1999) (9th Cir. 1999) ("deliberate" recklessness); In re Comshare Inc. Sec. Littig., 183 F.3d 542 (6th Cir. 1999); Bryant v. Avado Brands Inc., No. 98-9253, _____ F.3d ___, 1999 WL 688050, [Current] Fed. Sec. L. Rep. (C.C.H.) ¶ 90,636 (11th Cir. September 3, 1999) ("severe" recklessness); Phillips v. LCI International Inc., No. 98-2752, ___ F.3d ____, 1999 WL 717 253, [Current] Fed. Sec. L. Rep. (C.C.H.) ¶ 90,645 (4th Cir. September 15, 1999); Greebel v. FTP Software Inc., No. 98-2194, [Current] Fed. Sec. L. Rep. (C.C.H.) ¶ 90,658 (1st Cir. October 8, 1999) (definition of scienter includes recklessness, "closer to being a lesser form of intent").
26 Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).