November 30, 1999
Jonathan G. Katz
Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W. Stop 6-9
Washington, DC 20549
E-Mail address: rule-comments@sec.gov
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 and Gentlemen:
The Securities Law Committee of the American Society of Corporate Secretaries (the "Society") is pleased to provide comments to the Securities and Exchange Commission on the proposed rules in the NYSE Proposal, Amex Proposal and NASD Proposal. The Society, with more than 4,000 members, represents over 2,700 public companies. We believe that our members, who serve as the interface between management, the company's directors and its shareholders, are in a unique position to provide insight and discerning perspectives on the issues raised in the Release.
The Proposals arise out of the Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees ("BRC Recommendations"), and are part of a three-pronged approach for implementation by the Commission, stock exchanges, and the American Institute of Certified Public Accountants ("AICPA").
While the Proposals and rules of the NYSE, Amex and NASDAQ (the "Exchanges") need not be the same, we believe it is helpful to consider the three Proposals together. Accordingly, we are commenting on all three Proposals in this letter.
The Proposals of the Exchanges, plus the separate, companion rule proposals of the Commission and the AICPA, represent an ambitious undertaking to implement the Recommendations of the Blue Ribbon Committee ("BRC"). The general stated objective to make audit committees more effective is one that the Society and its members support. Our comments are directed to how to best accomplish that objective.
There is much in the Proposals that the Society can support. The Society agrees with the requirement for an independent audit committee and exclusion of Employees, Immediate Family members, and directors with a Cross Compensation Committee Link, as defined in the Proposals. We generally agree with providing for the determination by the board of directors of disqualifying Business Relationships, provided that the definition is aligned with Item 404 of Regulation S-K and other modifications are made that we propose below. We also believe it is good corporate governance to require an audit committee charter specifying the scope of responsibilities, but we would leave the specific content to each company by changing part of the required charter provisions to suggested Best Practices.
We support the proposed requirements for financial literacy as interpreted by the board of directors in its business judgment, but we have serious concerns with the requirement that at least one member have accounting or financial expertise. As a practical matter, the proposed rule would create two classes of directors: those who can serve on the audit committee and those who cannot. This would prevent rotation by board members among all board committees, which would clearly detract from the ability of directors to develop the broad committee experience and knowledge about a company that over time can significantly contribute to the overall effectiveness of a board.
Finally, we strongly oppose any requirement for certifying or affirming to the Exchanges the audit committee provisions because that would impose on directors the responsibility to certify compliance with vague or non-existent standards with the potential for increased litigation and liability, discourage qualified directors, and increase costs and other burdens.
Audit Committee Charter
The NYSE, NASD and Amex generally accepted BRC Recommendations 4, 6 and 7 relating to the charter of the audit committee, and have proposed rules reflecting those recommendations. The Commission also has proposed related rules which call for disclosure of whether issuers have taken certain actions that are the subject of the Exchanges' proposed rules.
1. Adoption of Formal Charter
The Society supports requiring the adoption of an audit committee charter that describes in general terms the functions and responsibilities of the audit committee. We believe it is good governance for a company to have a written audit committee charter. In fact, in a recent Society survey of approximately 400 of its NYSE member companies and 150 of its NASDAQ companies, fully two-thirds of its respondent companies stated that their audit committees already have written charters.
2. Content of Charter
In general, the Society does not believe that the actual content of an acceptable audit committee charter should be determined by rule-making, as proposed by the Exchanges, but rather that a charter is best developed by each company's board of directors and audit committee on a case-by-case basis.
Having said that, we believe the following proposed best practices are appropriate for audit committee charters, and we could support recommending them as guidelines:
We urge that the remaining content of the charter be left to each company, although the Exchanges may propose certain recommended provisions. We note that one of the proposed provisions of the Proposals uses obligatory language that the committee is responsible to ensure that the auditors submit information on other services provided to the company (e.g., NYSE proposed Rule 303.01(B)(1)(c)). We believe that this item, even if proposed as a recommended provision, should be worded as a "recommended function of the audit committee to review the auditor's submission on independence."
3. Annual Review and Reassessment of Audit Committee Charter / Certification or Affirmation
The Exchanges have proposed that the audit committee be required to review and reassess the adequacy of its charter on an annual basis. In addition, the Proposals would require ongoing, periodic written affirmations and certifications as to the proposed annual review of adequacy and other proposed audit committee conditions and requirements.
The Society believes that periodic review by the audit committee of its charter could prove beneficial and useful by focusing and encouraging discussion among audit committee members on their responsibilities as expressed in the charter. However, we do not believe review is necessary or would be helpful every year. Once a charter has been set, it is more productive for the committee to spend its time reviewing financial data than dealing with a bureaucratic checklist.
We believe the provision on review and reassessment of the audit committee charter should be a recommended best practice, without specifying the frequency of the review and without requiring assessment of the "adequacy" of the charter.
The Society strongly objects, however, to the proposal of the Exchanges to require an ongoing certification or written affirmation.1
Any proposal for requiring listed companies to make compliance certifications or affirmations to the Exchanges raises many troublesome issues. The BRC Recommendations did not require certification or affirmation to the Exchanges. The Society questions why the Exchanges would propose to treat the matters addressed by these rules any differently from the many other current listing standards applicable to listed companies, and would require what in essence would be a periodic compliance certification by listed companies.
The Society believes that this proposed certification / affirmation requirement creates a burden to certify determinations that have no standards or vague standards at best, or determinations that do not lend themselves to a simple comply or non-comply conclusion. This requirement would impose a time-consuming, paper-intensive burden on companies, which will not enhance the quality of the audit committee's performance, or the qualifications of the audit committee's members, and may subject companies and their directors to potential litigation and liability. We consequently urge the deletion of any written certification or affirmation requirements.
Composition of Audit Committee
1. Independence
a. Employment, Cross Compensation Committee Link, Family Membership. The Society fully supports the proposition that members of the Audit committee should be independent. The Society agrees with excluding from the definition of independence those directors who: (1) are (or within 3 years were) employees of the listed firm; (2) are family members of executives of the listed firm; or (3) whose executive compensation is determined by a Compensation Committee on which an executive of the listed company serves. The Society also supports the proposed rule which allows the board to exercise its business judgment in exceptional circumstances to override the three-year employment limitation for one director who is not, or whose Immediate Family member is not, presently an employee.
b. Business Relationship. The Society wholeheartedly supports the requirement that no director should serve on the audit committee in the face of a business relationship that would interfere with the exercise of independent judgment. Thus, the Society has no issue with the desired result; our comments concern only the means to achieve the desired result.
As we read the proposed NYSE rule, all business relationships involving directors who may serve on the Audit committee would have to be disclosed to the Board which will then determine, taking into account materiality and other factors, whether the director meets the independence standard. The definition of "business relationships" is broad and includes relationships with an entity which merely employs the director - - not even in an officer capacity - - no matter how small. Read literally, a $1,000 transaction would need to be brought to the Board to determine that such a transaction would not interfere with the director's exercise of independent judgment.
It is clear that some quantitative threshold is necessary for advising the board of business transactions or other relationships in order to make this provision workable. Although the current $60,000 threshold provision of Regulation S-K 404 is much too small and results in burdensome searches for transactions that are trivial to the companies involved, S-K 404 has the advantage that listed companies are already performing the necessary procedures. The Amex and NASD Proposals incorporate the $60,000 and 5 percent of revenues thresholds of S-K 404 in defining independence.
Accordingly, the Society urges that the proposed NYSE rule consider only transactions exceeding the proposed Amex and NASD thresholds. This would not only provide efficiency and consistency to a tedious and burdensome due diligence process, but more importantly, would bring to the board's consideration only those transactions which could possibly cast doubt on the director's independence. The S-K 404 thresholds include transactions that the Commission has determined should be brought to the attention of shareholders and consequently should be considered for determining independence from management and the company.
Our suggested changes can be accomplished by the following modifications to the NYSE Proposal:
Replace the first sentence of the second paragraph of proposed NYSE Paragraph 303.01(B)(3)(b) with the following:
"Business relationships" are the following transactions:
(i) payment of any compensation by the corporation or any of its affiliates to the director 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
(ii) payments made by a for-profit organization in which the director is a partner, controlling shareholder or executive officer ("Related Company") to the corporation, or payments made by the corporation to a Related Company (other than those arising solely from investments in the corporation's securities), in either case 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.
(iii) Except for relationships specified in Paragraph 303.01(B)(3)(a), (c) and (d), any transaction or relationship that is not included in the definition of "business relationship" shall not disqualify a director from being independent under Paragraph 303.01(B)(2)(a).
In addition, both the Amex and NASD incorporate a portion of Regulation S-K 404 in their proposals. We suggest that the Amex and NASD conform their proposals to the provisions suggested above for the NYSE.
c. Determination of Independence. Proposed NYSE Paragraph 303.01(B)(2)(a) does not specify who is to make the determination of independence. We suggest that the NYSE add at the end of 303.01(B)(2)(a): "as determined by the Board of Directors in its business judgment." This is consistent with other board determinations in the NYSE Proposals that provide the board with the benefit of the business judgment rule. We suggest that the Amex and NASD, which already provide for the board to make the determination of independence, also add "in its business judgment."
2. Financial Literacy / Accounting or Related Financial Management Expertise.
The NYSE Proposal would require that all audit committee members be financially literate, as such standard is interpreted by the board in its business judgment, and that at least one member have accounting or financial management expertise, again, as interpreted by the board. Amex and NASD are similar but spell out more of what constitutes literacy and expertise without reference to a board interpretation. We suggest that the Amex and NASD also provide for interpretation by the board in its business judgment.
We think most parties will agree that an audit committee member should be financially literate. We also agree with the NYSE Proposal that the board of directors in its business judgment should interpret what constitutes financial literacy. We believe that the main concern parties have with this provision is knowing exactly what constitutes financial literacy. We suggest that the NYSE adopt the NASD and Amex description to be used as a guide in determining what qualifies as financially literate. This can be accomplished by adding the following to the NYSE proposed rule.
The ability to read and understand fundamental financial statements, including a company's balance sheet, income statement, and cash flow statement, shall constitute financial literacy for purposes of the interpretation of "financially literate" by the Board of Directors in its business judgment.
It is more difficult to reach a consensus on requirements for accounting or financial expertise. While most of our member companies reported in a recent survey that at least one member of their audit committee had a finance or accounting background, a significant number of our members currently do not meet that standard and are opposed to such a requirement. Board members with legal or other non-financial backgrounds may be acceptable substitutes for small boards that do not currently have board members with a formal financial background. As proposed, the rule offers no flexibility for a board whose remaining choice may be to recruit a new qualified board member.
The Society opposes the present Proposal that would require at least one committee member to have accounting or related financial management expertise because it could: (1) arguable subject the designated director to a higher standard of care and heightened potential liability, which could reduce the pool of qualified directors willing to serve on corporate audit committees; (2) require that interpretations or determinations be made of vague standards; (3) subject boards of directors to additional potential liability and litigation based on claims that the board did not adequately interpret or define accounting or financial expertise; (4) divert the audit committee away from its role of oversight and review into separately taking on some of the responsibilities of financial management and the outside auditors; and (5) impose an unnecessary burden on companies with smaller board.
Our survey results suggest a formulation that we believe will encourage a Best Practice most can agree on without the drawbacks of the current Proposals. The Society proposes that the Exchanges change their Proposals to provide a recommended Best Practice that listed companies consider financial background in selecting members of the audit committee. We believe few companies would deviate from such a standard except in situations where current board composition made compliance impossible.
Transition Period
The NYSE Proposal has two different provisions. Companies with less than three members on their audit committees would have eighteen months to recruit the requisite qualified members. Also, currently qualified audit committee members would be "grandfathered" until they are re-elected or replaced. No transaction period is proposed for other requirements. We urge the Exchanges to adopt January 1, 2001 as a uniform effective date for the new rules, assuming adoption in the near future. This would provide all companies time to implement the new rules, schedule meetings, develop charter provisions, recruit qualified directors, etc., in a careful manner.
The Society appreciates this opportunity to comment on the Proposals and participate in the effort to improve corporate audit committees. If you have any questions on our views, please let us know. We would be pleased to discuss our views further with the Commission and the Exchanges.
Sincerely,
/s/ MARGARET M. FORAN
Margaret M. Foran
Chair
Securities Law Committee
/s/ MICHAEL J. HOLLIDAY
Michael J. Holliday
Co-Chair
Corporate Audit Committee Task Force
/s/ KATHLEEN A. WEIGAND
Kathleen A. Weigand
Co-Chair
Corporate Audit Committee Task Force
Copy to: The Honorable Arthur Levitt
The Honorable Paul R. Carey
The Honorable Isaac C. Hunt, Jr.
The Honorable Norman S. Johnson
The Honorable Laura S. Unger
New York Stock Exchange, Inc.
American Stock Exchange LLC
National Association of Securities Dealers, Inc.
The Nasdaq Stock Market, Inc.
1 This provision seems to be particularly unnecessary insofar as the composition of the audit committee is concerned in light of the proxy statement disclosure of the committee composition.