November 18, 1999
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609
Re: Audit Committee Disclosure (File No. S7-22-99)
Dear Mr. Katz:
I respectfully submit this letter in response to the Commission's request for comment on the proposed rules regarding Audit Committee Disclosure.
As a threshold matter, permit me to make clear that I submit this letter purely as a private citizen. The views expressed below are only my own, which is to say that I do not seek to present the views of any particular committee, client, or, for that matter, even of my partners. Thus, I submit this letter simply as a student of financial reporting and one who is very much interested in sound corporate governance and the integrity of financial reporting systems.
Permit me also to convey that I am an earnest and enthusiastic supporter of what the Commission, along with the SROs and the AICPA, is seeking to accomplish. In particular, I am a strong advocate of the importance of the audit committee in overseeing the financial reporting process, in the concept of an "open and frank" dialogue with the outside auditor and internal audit, and in the underlying premise that an audit committee should be asking "tough questions" in fulfillment of its responsibilities. For that reason, I sought to premise my recent book on the subject on precisely such concepts.
There is one aspect of the Commission's proposals, however, with which I strongly disagree. That is the proposed requirement that a company's proxy statement include a statement by the audit committee as to whether "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 . . . 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."
I want to make clear that my concern about this provision is not rooted in a concern about a potential increase in legal liability. That may happen, but I view that as purely a secondary concern. My primary concern, rather, stems from the belief that this proxy statement disclosure requirement will compromise, and potentially eviscerate, a viable audit committee function.
The reason is this. The Commission is absolutely correct that critical to viable audit committee oversight is an active audit committee which probes deep to understand the strengths and weaknesses of a financial reporting system. That is, indeed, the essence of oversight -- asking tough, probing questions; uncovering weaknesses; and doing something about them. These concepts, of course, penetrate the very fiber of the Treadway Commission report of thirteen years ago, and are very much present in the Commission's recent proposals.
The problem with the proxy statement requirement is that it will provide a strong incentive for audit committees to retreat from their oversight function out of fear that the discovery of financial reporting weaknesses will trigger the need for disclosure of them in the proxy statement. Rather than asking tough probing questions, the audit committee may retreat into procedural formalism, in which the key objective becomes getting through its checklist of tasks without learning of potentially disclosable weaknesses. Already, this is happening. After giving a speech to the Institute of Internal Auditors several weeks ago, one internal auditor approached me to describe the admonition he had been given by his audit committee: "Whatever you do, do not report to us any problems."
Now I understand completely that the actual disclosure requirement is more limited than my concern seems to imply. By its terms, it requires disclosure only of information suggesting that the financial statements may be false or misleading. It seems intuitively self-evident that, if an audit committee member thinks financial statements are false or misleading, it ought to let the public know -- or, more to the point, see that they are corrected so no proxy statement disclosure is required.
The problem, though, is that that is not necessarily how audit committees (or their lawyers) will react to the proxy statement disclosure requirement. Instead, they may do their best to avoid completely the risk of proxy statement disclosure by making sure they do not learn of system inadequacies to begin with.
Let me give an example. Suppose a properly-functioning audit committee were to be told by the internal auditors of a "tone at the top" concern that corporate sales representatives may be under too much pressure at quarter-end and that, while they're not aware of anything tangible, they are concerned that this quarter-end pressure runs the risk of giving rise to quarter-end discounts that are not being candidly reported to the accounting department. As an aside, this is precisely the type of environmental information that a properly-functioning audit committee should seek to obtain. Receipt of this kind of information gives the audit committee the opportunity to delve into the problem, to raise it with senior management, and to see that appropriate "tone at the top" modifications are made.
However, if an audit committee receives this information, does that require proxy statement disclosure? Probably not, but audit committees are not going to want to run the risk. That is particularly so insofar as the plaintiffs' bar would inevitably argue in a section 10(b) action that it was precisely this kind of information of which the SEC's new rules mandated disclosure. We can argue about whether this in fact would happen or not, but one thing we cannot argue about. This will be an important concern of securities lawyers advising audit committees. And -- and of this I'm entirely confident -- cautious lawyers will advise audit committees to put in place systems whereby they can technically fulfill their responsibilities without running the risk of learning potentially-disclosable bad news.
It is thus that the proxy statement disclosure requirement stands to compromise, rather than enhance, audit committee effectiveness. Rather than affirmatively seeking bad news, audit committees will seek to avoid its receipt. Effective oversight by a committee that receives only favorable reports is impossible. Hence, the audit committee function may turn into even less than it is now.
I would therefore earnestly encourage the Commission to drop this disclosure requirement. More than that, I would submit the view that it is absolutely unnecessary. Increasingly, audit committee members are coming to appreciate the increased expectations being placed upon them. That appreciation will be furthered by the other aspects of the proposed rules. In so many respects the Commission's proposals are outstanding. It would be exceedingly unfortunate to see them compromised by the inclusion of this proxy statement requirement.
Again, I reiterate that these are only the views of one private citizen. However, if you would like to explore them further -- and in particular the reason for the strength of my view that audit committees must be encouraged, rather than discouraged, to solicit bad news -- I would be more than willing to fly to Washington (at my own expense) to discuss them in greater detail. Such is my conviction that this proxy statement disclosure requirement is completely contrary to everyone's interest in financial reporting.
Michael R. Young
cc: Mr. Lynn E. Turner
Mr. W. Scott Bayless
Mr. Robert E. Burns
Via Federal Express