New York State Bar Association
One Elk Street
Albany, NY 12207
518-463-3200
Business Law Section
Committee on Securities Regulation
December 1, 1999
Securities and Exchange Commission
450 Fifth Street N.W.
Mail Stop 6-9
Washington, DC 20549
E-mail address: rule-comments@sec.gov
Attention: Jonathan G. Katz, Secretary
Re: Proposed Rule Change by the New York Stock Exchange, Inc. Amending Audit Committee Requirements of Listed Companies ("NYSE Proposal")
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Proposed Rule Change by the American Stock Exchange LLC Amending the Exchange's Audit Committee Requirements ("Amex Proposal")
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Proposed Rule Change by National Association of Securities Dealers, Inc. Amending Nasdaq's Audit Committee Requirements ("NASD Proposal")
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Ladies & Gentlemen:
The Committee on Securities Regulation of the Business Law Section of the New York State Bar Association appreciates the opportunity to comment on the NYSE, Amex and NASD Proposals (collectively the "Proposals").
The Committee on Securities Regulation is composed of members of the New York State Bar Association, a principal part of whose practice is in securities regulation. The Committee includes lawyers in private practice and in corporation law departments. A draft of this letter was circulated for comment among members of the Committee and the views expressed in this letter are generally consistent with those of the majority of the members who reviewed the letter in draft form. The views set forth in this letter, however, are those of the Committee and do not necessarily reflect the views of the organizations with which its members are associated, the New York State Bar Association, or its Business Law Section.
A. GENERAL
We appreciate the opportunity to provide comments to the Securities and Exchange Commission on the proposed rules in the NYSE Proposal, Amex Proposal and NASD Proposal, which are intended to give effect to certain of the Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. Because we believe it is more efficient to consider the Proposals and rules of the NYSE, Amex and NASDAQ (the "Exchanges") together, this letter addresses all three Proposals.
We agree with the overall goal of the Exchanges and the Commission to improve the effectiveness of corporate audit committees. We support the requirement that each audit committee have a formal written charter and that all audit committee members be independent and financially literate, provided that the modifications we propose below are made to the Proposals. We also could support a requirement that the board of directors annually review the charter. But, for the reasons discussed below, we oppose any rule or requirement that would require: (1) periodic assessment of adequacy, affirmation and certification with respect to the audit committee and charter, independence, financial literacy, or accounting or financial expertise; or (2) that at least one member have an accounting or financial expertise, background or experience.
B. FORMAL AUDIT COMMITTEE CHARTER
a. Charter Adoption
We believe that audit committees, as well as other board committees, should have a written document specifying the functions of the committee. This is only good corporate governance. We also believe that most companies presently have a written statement setting forth the authority and functions of the audit and other board committees, which often may be contained in the board resolutions establishing the committee. Therefore, we can support the requirement that audit committees have formal written charters as constituting good governance, without adding significant burdens or potential liability to listed companies and their directors.
The board of directors, which has ultimate responsibility under state corporate law, should adopt the audit committee charter, and not the audit committee. The audit committee is a creation of the board, and exercises authority and performs functions to the extent determined by the board. Therefore, the NYSE Proposal should be modified accordingly.
b. Charter Content
We do, however, have serious concerns with prescribing some of the provisions that would be required for the charter, and with the requirements for periodic assessment, affirmation and certification.
Each company and its board of directors generally should have the discretion to determine the specific functions and responsibilities that will be allocated to the audit committee. We believe that certain of the proposals for the charter are consistent with that position. Specifically, we agree that the audit committee charter should: (1) set forth the scope of the committee's responsibilities, and its structure and membership requirements; (2) establish that the outside auditor is responsible to the board of directors and the committee; and (3) establish that the audit committee is to recommend to the board the selection and replacement of the outside auditor.
Therefore, we agree with NYSE proposed Rule 303.01(B)(1)(a) and (b), and the similar Amex and NASD proposals, provided that the proposed rules clarify that the role of the audit committee is to "recommend" the selection and replacement of the outside auditor. The actual decision to select or replace properly belongs with the board.
On the other hand, we oppose the Exchanges' proposed rules that would mandate specific language regarding determination of the independence of the outside auditor, which could lead to disputes over what the charter provision means. Questions over whether charter provisions had been complied with ultimately could be claimed by plaintiffs' attorneys to be a basis for lawsuits against audit committee members, which is not the intention of the Proposals. The potential for litigation and possible liability is of particular concern for this rule where the mandated provisions are written in a manner to suggest standards of care for audit committee members. The NYSE rule would require the audit committee to "ensure" that the outside auditors submit their report on other engagements with the company, and then discuss with the auditors and recommend action to the board to "ensure" the independence of the auditor.
Other than the rules we support above, any proposals should be sample or model charter provisions without mandating specific language and making clear that the provisions of the charter and the actual wording are in the discretion of the board of each company. The provision on auditor independence (NYSE Rule 303.01(B)(1)(c)) should be changed, for example, by making it a suggested charter provision and substituting that the committee will request and review the report from the auditors on consulting services and independence rather than requiring the committee to "ensure" that the report is provided and the auditors are independent.
c. Charter Reassessment, Review, Affirmation and Certification
We would support a requirement for the board of directors to review the audit committee charter annually. However, we strongly oppose the proposals for the audit committee to assess the adequacy of the charter. Because the content and interpretation of the charter ultimately should be in the discretion of the board of directors of each company, it is not meaningful to have an assessment of the charter or the adequacy of the charter. The charter states what the board in each case determines is appropriate. Furthermore, there is no standard to measure the adequacy of the charter. It is enough to require each company to have a written audit committee charter setting forth the functions of the committee.
For similar reasons, we oppose the proposals for periodic affirmations and certifications. We have serious doubts as to a legitimate basis for the Exchanges to assume a quasi-legislative role with respect to listed companies. These provisions were not even in the Blue Ribbon Committee recommendations. They raise more questions as to what the proper role of the Exchanges is than what the role of the audit committee should be. Such a change in the role of these private organizations should have meaningful input and analysis by listed companies, legal practitioners and academicians and securities industry professionals before being formulated and proposed. In any event, they should not be adopted here as part of the fast-track audit committee proposals which have been widely publicized and commented on.
C. AUDIT COMMITTEE COMPOSITION
a. Independence
We agree with the Proposals that members of the audit committee should be independent. We support the definitions of independence in the Proposals concerning (a) employment within 3 years with the firm; (b) family members of executives; and (c) cross Compensation Committee interlocks.
We believe that in the more difficult area where subjective judgment as to independence is involved, the determination should be made by the board of directors in the exercise of its business judgment. Therefore, we agree with the approach taken in the NYSE proposed Rule 303.01(B)(3)(b) regarding disqualifying business relationships. However, the NYSE should modify its proposed Rule 303.01(B)(2)(a) which provides the general definition of independence to expressly provide that independence is to be determined by the board of directors in its business judgment, in order to clarify who ultimately is to make the decision and extend the benefit of the business judgment rule to directors in this case. Amex and NASD, who also provide for the board to make the determination of independence, should add "in its business judgment."
We urge the NYSE, however, to consider adopting objective thresholds for transactions, above which the board of directors would determine independence in its business judgment, and below which would be a safe harbor that would not constitute disqualification from being independent. For example, the Amex and NASD Proposals incorporate the $60,000 and 5% of revenues criteria of Regulation S-K 4041. That approach has the advantage of being based on transactions already required to be reported under Regulation S-K 404, thereby avoiding any new burdensome process to gather information. Therefore, we suggest that Paragraph 303.01(B)(3)(b) of the NYSE Proposal be modified to require the board of directors to determine in its business judgment whether any of the following transactions would interfere with the director's exercise of independent judgment:
(1) receipt by the director of compensation from the corporation or any of its affiliates in excess of $60,000 during the previous fiscal year, other than compensation for board service, benefits under a tax-qualified retirement plan, or non-discretionary compensation; or
(2) payments received by the corporation from a for-profit organization in which the director is a partner, controlling shareholder or executive officer ("Related Company"), or payments made by the corporation to a Related Company (other than those arising solely from investments in the corporation's securities) in excess of 5% of the corporation's or the Related Company's consolidated gross revenues for that year, or $200,000, whichever is more, in any of the past three years.
In addition, the proposed Rule should provide that transactions and other relationships not exceeding the threshold of (1) or (2) above, other than relationships covered by Paragraph 303.01(B)(3)(a), (c) or (d) of the NYSE rule (employment, family member, Compensation Committee interlock), should not disqualify a director from being Independent.
The Amex and NASD should modify their proposals similarly to establish the $60,000 and 5% of revenues (or $200,000) amounts as thresholds, above which the board will determine independence in its business judgment, and below which would not be a disqualification from independence.
b. Financial Literacy and Accounting / Financial Expertise
We agree with the NYSE Proposal that all audit committee members should be financially literate, as interpreted by the board of directors in its business judgment.
We do have a concern as to how to define or determine "financial literacy." Here, the Amex and NASD Proposals offer guidance. They would require all audit committee members to be able to read and understand fundamental financial statements, including a company's balance sheet, income statement, and cash flow statement. We suggest that the NYSE adopt the same formulation and provide that financial literacy shall mean "the ability to read and understand fundamental financial statements, including a company's balance sheet, income statement, and cash flow statement as determined by the board of directors in the exercise of its business judgment."
We strongly oppose, however, any requirement that a member of the audit committee have a finance or accounting background, expertise or experience. First of all, identifying a committee member as an accounting or finance expert may be inconsistent with or undercut the director's ability to claim statutory defenses under the Federal securities laws and state law based on reliance on accounting and other experts and on management. This would be opening up a whole new avenue of possible liability that may be pursued by plaintiffs' lawyers.
Being the designated expert on the audit committee also may be argued by plaintiffs' attorneys to create a higher standard of care for the specific director with a resulting increase in exposure to liability.
We believe that the additional risks of individual liability from imposing the accounting / financial expertise or experience requirement will reduce the number of qualified directors willing to serve on audit committees.
An even more fundamental problem with the proposal is that it blurs the distinction between the review and oversight function of the audit committee and the responsibilities of the corporation's management and accounting organization and the independent auditors. There is no way that the audit committee, and individual committee members, can spend the time and obtain the information about the corporation to be able to substitute their expert judgment for that of the corporation's accounting and finance professionals and the independent auditors. Requiring one member to have accounting / finance expertise will not change that; it can only lead to increasing the potential for litigation and liability and discouraging directors from serving on audit committees.
c. Grandfather Provision
The NYSE proposes to give companies that have less than three members on their audit committees eighteen months to recruit the requisite qualified members. On the other hand, the NYSE proposes to "grandfather" all currently qualified audit committee members until they are re-elected or replaced. Companies who currently have three or more members would have only until their next annual elections to replace any non-qualified members. Presumably, if the three plus member company ended up with less than three qualified members, it would have the benefit of the 18 month provision to get up to three qualified members. There does not seem to be any reason to remove a member qualified under the present rules pending replacement with a qualified director within the 18 month provision. In view of the lead time to schedule meetings, develop charter provisions, recruit potential qualified directors, etc., the Exchanges should allow an 18 month transaction period from adoption for the effectiveness of all of the Proposals. This would permit all companies to implement the new rules in a careful and thoughtful manner. Certainly, attempting to adopt the new rules to have them effective for the upcoming year 2000 annual meeting of shareholders and board organization meetings would not allow sufficient time.
We hope that you will find these comments helpful. We would be happy to meet with you or the Exchanges to discuss these comments further.
Respectfully submitted,
COMMITTEE ON SECURITIES REGULATION
/s/ GUY P. LANDER / by MJH
Guy P. Lander
Chairman of the Committee
Drafting Committee:
Michael J. Holliday
Gerald S. Backman
Richard E. Gutman
Copy to:
The Honorable Arthur Levitt, Chairman
The Honorable Paul R. Carey, Commissioner
The Honorable Isaac C. Hunt, Jr., Commissioner
The Honorable Norman S. Johnson, Commissioner
The Honorable Laura Simone Unger, Commissioner
New York Stock Exchange, Inc.
American Stock Exchange LLC
National Association of Securities Dealers, Inc.
The Nasdaq Stock Market, Inc.
1 The Amex and NASD Proposals use a greater of 5% of revenues or $200,000 test, which has the effect of specifying a $200,000 threshold for all companies with less than $4,000,000 annual revenues. This is a practical solution for start-up companies, which we include in our proposal.