SEC Audit committee memo 2
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TO OUR FRIENDS AND CLIENTS April 24, 2003 SEC Adopts Audit Committee Standards for Listed Companies The Securities and Exchange Commission has adopted new rules regarding the audit committee requirements established by the Sarbanes-Oxley Act. The rules prohibit the New York Stock Exchange, Nasdaq and other national securities exchanges and associations from listing any security of an issuer that does not meet the following standards: • Each member of the issuer's audit committee must be "independent". • In order to be deemed independent, an audit committee member must not accept, directly or indirectly, any consulting, advisory or other compensatory fees from the issuer or a subsidiary and may not be an "affiliated person" of the issuer or any of its subsidiaries. A Partnership Including Professional • The audit committee of each issuer must be directly responsible for Corporations the appointment, compensation, retention and oversight of the New York work of any registered public accounting firm engaged for the One New York Plaza purpose of preparing or issuing an audit report or performing other New York, NY 10004 212.859.8000 audit, review or attest services for the issuer and the auditor must report directly to the audit committee. Washington, DC 1001 Pennsylvania Avenue, NW • Each audit committee must establish procedures for the receipt, Washington, DC 20004 retention and treatment of complaints regarding accounting, 202.639 ...
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T O O U R F R I E N D S A N D C L I E N T S
April 24, 2003
SEC Adopts Audit Committee Standards for Listed Companies
The Securities and Exchange Commission has adopted new rules regarding the audit committee requirements established by the Sarbanes-Oxley Act. The rules prohibit the New York Stock Exchange, Nasdaq and other national securities exchanges and associations from listing any security of an issuer that does not meet the following standards: • Each member of the issuer's audit committee must be "independent". • In order to be deemed independent, an audit committee member must not accept, directly or indirectly, any consulting, advisory or other compensatory fees from the issuer or a subsidiary and may not be an "affiliated person" of the issuer or any of its subsidiaries. • The audit committee of each issuer must be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm engaged for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the issuer and the auditor must report directly to the audit committee. • Each audit committee must establish procedures for the receipt, retention and treatment of complaints regarding accounting, internal accounting controls or auditing matters and procedures for the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters. • Each audit committee must have the authority to engage independent counsel and other advisors, as it determines necessary to carry out its duties.
Copyright © April 24, 2003 Fried, Frank, Harris, Shriver & Jacobson
A Partnership Including Professional Corporations New York One New York Plaza New York, NY 10004 212.859.8000 Washington, DC 1001 Pennsylvania Avenue, NW Washington, DC 20004 202.639.7000 Los Angeles 350 South Grand Avenue Los Angeles, CA 90071 213.473.2000 London 99 City Road London EC1Y 1AX United Kingdom 44.20.7972.9600 Paris 5, boulevard de la Tour Maubourg 75007 Paris France 33.140.17.04.04 www.friedfrank.com
SEC Adopts Audit Committee Standards for Listed Companies • Each issuer must provide appropriate funding for the audit committee to compensate the auditor and any other advisors engaged by the committee, as well as for ordinary administrative expenses. The SEC's rules apply to both U.S. and foreign private issuers, but the SEC has included a number of special exceptions designed to make it easier for foreign private issuers to comply. Issuers other than foreign private issuers and small business issuers are required to comply with the new rules by the earlier of (1) the issuer's first annual meeting of shareholders after January 15, 2004 or (2) October 31, 2004. Foreign private issuers and small business issuers must comply by July 31, 2005. In addition, the NYSE and Nasdaq have submitted to the SEC proposed amendments to their audit committee requirements, which add additional regulations relating to audit committees. The NYSE and Nasdaq proposals regarding independence and responsibilities of audit committee members must be approved by the SEC by December 1, 2003. A. Audit Committee Member Independence 1. Criteria Each member of the audit committee is required to be an "independent" member of the board of directors. In order for an audit committee member to be considered independent, the audit committee member cannot, other than in his or her capacity as a member of the audit committee, the board of directors, or any other committee: • accept directly or indirectly any consulting, advisory or other compensatory fee from the issuer or any of its subsidiaries, or • be an affiliated person of the issuer or any of its subsidiaries. a. Compensatory Fees. Audit committee members may not, directly or indirectly, accept any consulting, advisory or other compensatory fees from the issuer or any of its subsidiaries. There is no "de minimis" exception to this restriction. In addition, audit committee members are prohibited from accepting payments as an officer or employee of an issuer, as well as other compensatory payments. Directors and committee member fees, however, are not prohibited. Further, if the director is also a shareholder, payments made to all shareholders of the class generally, such as dividends, are permitted. Finally, unless a self regulatory agencys, or SRO's, listing rules provide otherwise, the SEC's rules permit audit committee members Fried, Frank, Harris, Shriver & Jacobson
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April 24, 2003
SEC Adopts Audit Committee Standards for Listed Companies to receive fixed amounts of compensation under a retirement plan (including deferred compensation) for prior service with the issuer (provided that such compensation is not contingent in any way on continued service). The indirect acceptance of compensatory payments includes payments to spouses, minor children or stepchildren or children or stepchildren sharing a home with the member. The SEC's rules only cover a limited group of family members and do not extend to the broad categories of family members that may be reached by the proposed rules of self regulatory organizations such as the NYSE and Nasdaq. For example, the NYSE's definition of "immediate family member" in its proposed rules would include a person's parents, spouse, children, siblings, mothers and fathers-in-law, sons and daughters-in-law brothers and sisters-in-law and anyone other than domestic employees who shares such person's home. Indirect payments also include payments accepted by an entity (1) in which an audit committee member is a partner, member (except limited partners, non-managing members and those occupying similar positions, who in each case have no active role in providing services to the entity), officer such as a managing director occupying a comparable position or executive officer or in which the audit committee member otherwise occupies a similar position and (2) which provides accounting, consulting, legal, investment banking or financial advisory services to the issuer or any subsidiary. The SEC noted that the list of covered persons does not extend to every employee of an associated entity, but is intended to include those persons, such as partners or members in professional organizations, regardless of control, whose compensation could be directly affected by the prohibited fees, even if they are not the primary service provider. Although the final rules deleted the term "principal" from the list of covered persons, the SEC noted in the adopting release that "we believe the reference to 'those occupying similar positions' covers entities such as professional corporations that use the 'principal' designation for positions similar to a partner in a partnership." The adopting release states that the payment restrictions only relate to entities providing "accounting, consulting, legal, investment banking or financial advisory services" and would not cause a director to lack independence on the basis of other commercial business relationships between an issuer and an entity with which a director had a relationship. For example, the prohibition on payments to entities does not cover non-advisory financial services such as lending, check clearing, maintaining customer accounts, stock brokerage services or custodial and cash management services. The SEC noted, however, that it expects that the SROs' own listing standards will impose restrictions on additional services and activities.
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April 24, 2003
SEC Adopts Audit Committee Standards for Listed Companies The final rules only apply the prohibition to current relationships between the issuer and the audit committee member (and related persons). They do not extend to a "look-back" period before a director's appointment to the audit committee, although the NYSE and Nasdaq include look-back provisions in their pending independence proposals. b. Affiliated persons. A member of the audit committee of an issuer that is not an investment company may not be an "affiliated person" of the issuer or any subsidiary of the issuer, apart from his or her capacity as a member of the board and any board committee. An "affiliate" of, or a person "affiliated" with, a specified person, is defined, consistent with other SEC rules, as "a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the person specified." The rules define "control" as "the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise." This definition is also consistent with other current SEC rules. The determination as to whether a person is an "affiliate" must be made based on a consideration of all relevant facts and circumstances. Any person who is neither an executive officer nor a shareholder beneficially owning 10% or more of any class of voting equity securities of the issuer would be deemed not to control the issuer. Outside of this safe harbor, affiliate status depends on whether the person controls, is controlled by, or is under common control with, the issuer, based on a facts and circumstances analysis. 1 The final rules include an instruction stating that the existence of the safe harbor does not create a presumption in any way that a person who owns more than 10% controls or is otherwise an affiliate of a specified person. The final rules provide that an affiliate's executive officers, inside directors, general partners and managing members will be deemed to be affiliates. The SEC's original proposal would have deemed "a director, executive officer, partner, member, principal or designee of an affiliate" to be an affiliate. The SEC's adopting release explains that the reference to executive officers, general partners and managing members of an affiliate includes the positions we intend to cover. This will help clarify that passive, non-control positions, such as limited partners, and those that do not have policy making functions, are not covered. The formulation for being deemed to be an affiliate is narrower than the 1 Although the safe harbor provides some clarification with respect to the term "control", it does not address the question of whether a person "is controlled by or is under common control with" the issuer. Fried, Frank, Harris, Shriver & Jacobson
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April 24, 2003
SEC Adopts Audit Committee Standards for Listed Companies formulation of covered positions for the indirect acceptance aspect of the 'no compensation' prong due to their different purposes. We believe a wider formulation is necessary for the 'no compensation' prong to capture those whose compensation is more directly linked to fees from the prohibited services but who otherwise do not hold executive positions. Finally, we have removed the term 'designee.' However, consistent with our historical interpretations of the term 'affiliate,' an affiliate could not evade the prohibition in the rule simply by designating a third party representative or agent that it directs to act in its place. 2. Exemptions from Audit Committee Independence Requirements The final rules contain certain exemptions from the audit committee independence requirements: a. New Company Exemption: The final rules exempt all but one member of the audit committee from the independence requirements at the effective time of an issuer's initial registration statement under Section 12 of the Securities Exchange Act of 1934 or the issuer's initial registration statement under the Securities Act of 1933, if the issuer immediately prior to the effective date was not required to file reports pursuant to Sections 13 or 15(d) of the Exchange Act. A majority of the members must be independent, however, within 90 days from the effective date of the registration statement, and all audit committee members must satisfy the independence requirements within one year of the effective date of the registration statement. The proposed rule would only have allowed one member of the committee to be exempt for 90 days. b. Affiliate Over-Lapping Board Exemption: A committee member who sits on the board of directors of both an issuer and any of its affiliates is exempt from the "affiliated person" requirement if the audit committee member, except for being a director on each such board of directors, otherwise meets the independence requirements for each such entity, including the receipt of only ordinary-course compensation for serving as a member of the board of directors, audit committee or any other board committee of each such entity. This exception as proposed would have only covered a director who sat on the board of both a company and its consolidated majority-owned subsidiary. The exception was broadened to apply to a director sitting on the boards of a company and its affiliates in order to cover 50% joint ventures, sister companies and unconsolidated entities.
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SEC Adopts Audit Committee Standards for Listed Companies
c. Foreign Private Issuer Exemptions: The SEC also included exemptions in the case of foreign private issuers for non-management employees, controlling shareholders and foreign governmental board representatives. In addition, issuers that are foreign governments are exempt from all of the audit committee rules. These exemptions are discussed in Section G below. The SEC stated that it did not intend to consider case-by-case exemptions, waivers or no-action letter requests with respect to the audit committee independence requirements. The SEC emphasized, however, that it has exemptive authority to respond to, and will remain sensitive to, evolving standards of corporate governance, including changes in U.S. or foreign law, in order to address any new conflicts that cannot presently be anticipated. B. Responsibilities Relating to Auditors The audit committee rules require the audit committee to be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm engaged for the purpose of preparing or issuing an audit report or performing other "audit, review or attest services" for the issuer (including the resolution of disagreements between management and the auditor regarding financial reporting). 2 These requirements reinforce the SEC's recent amendments to its auditor independence rules. The new SEC rules also reiterate that the independent auditor must report directly to the audit committee. The SEC's adopting release clarifies that the auditor oversight responsibilities include the authority to retain (or not retain) and terminate the auditor. In addition, the audit committee must have the ultimate authority to approve all audit engagement fees and terms. In comparison, the SEC specifically declined to extend the oversight requirement to include oversight of the company's internal auditor.
2 The adopting release clarifies that, for purposes of these rules, "audit, review or attest services" include the same services covered in the "Audit Fee" category in an issuer's annual disclosure of fees paid to its auditors. This category includes services that normally would be provided by the accountant in connection with statutory or regulatory filings or engagements. In addition to services necessary to perform an audit or review in accordance with GAAS, the category may include services that generally only the independent accountant reasonably can provide, such as comfort letters, statutory audits, attest services, consents and assistance with and review of SEC filings. Fried, Frank, Harris, Shriver & Jacobson
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April 24, 2003
SEC Adopts Audit Committee Standards for Listed Companies C. Procedures for Handling Complaints The rules require each audit committee to establish its own procedures for the receipt, retention and treatment of complaints received by the issuer regarding accounting, internal accounting controls or auditing matters and the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters. The SEC specifically elected not to mandate specific procedures that every audit committee must establish. Given the variety of issuers in the U.S. capital markets, the SEC concluded that audit committees should be provided with flexibility to develop and utilize procedures appropriate for their circumstances. D. Authority to Engage Advisors The rules require an issuer's audit committee to have the authority to engage independent counsel and other advisors, as it determines necessary to carry out its duties. The SEC stated that this requirement would neither preclude the committee's access to, or ability to receive advice from, the company's internal counsel or regular outside counsel, nor require an audit committee to retain independent counsel. E. Funding The rules require each issuer to provide for appropriate funding, as determined by the audit committee, in its capacity as a board committee, for the payment of compensation to any auditor engaged for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the listed issuer and to any other advisors employed by the audit committee. In addition, the rules provide that an issuer must provide appropriate funding for ordinary administrative expenses of the audit committee that are necessary or appropriate in carrying out its duties. The SEC specifically declined to impose any limits on the amount of funding that the committee could request. F. Application of the Standards 1. Covered Issuers The rules only apply to companies which have listed securities. The rules apply not only to companies with listed equity securities, but also to any company that has any listed security, including debt securities, derivative securities and other types of listed securities. The SEC specifically declined to exempt companies with only listed debt securities or listed preferred securities from the scope of the rules. The audit committee rules do not apply, however, to a Fried, Frank, Harris, Shriver & Jacobson
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April 24, 2003
SEC Adopts Audit Committee Standards for Listed Companies company that has no listed securities, even if the company was otherwise subject to periodic reporting pursuant to Section 13(a) or 15(d) of the Exchange Act, such as an issuer with only unlisted debt securities. The rules only apply to securities listed on a "national securities exchange" or "national securities association." There are nine registered national securities exchanges, including the NYSE and AMEX, and only one registered national securities association, the NASD. The OTC Bulletin Board, the Pink Sheets and the Yellow Sheets will not be affected by the requirements and issuers whose securities are quoted on these interdealer quotation systems therefore will not be affected, unless their securities also are listed or quoted on an exchange or Nasdaq. 2. General Exemptions The SEC adopted limited exemptions from the audit committee requirements, including (among others) the following: a. Additional Listings . The SEC included an exemption from the audit committee requirements for companies with additional listings of securities on one or more different exchanges whenever the company is already subject to the audit committee requirements because it previously listed any class of its securities on an exchange subject to the requirements. b. Listings of non-equity securities of a subsidiary whose parent has listed equity securities . The SEC included an exemption from the audit committee requirements for listings of securities by a direct or indirect subsidiary that is consolidated or at least 50% beneficially-owned by a parent company, if the parent company is subject to the audit committee requirements as a result of the listing of a class of the parents own common equity securities. However, if the subsidiary were to list its own equity securities (other than non-convertible, non-participating preferred securities), the subsidiary would be required to meet the audit committee requirements. 3
3 The "multiple listing" exemptions described in (a) and (b) above are available to U.S. subsidiaries if the parent is a foreign private issuer, even if the foreign parent is relying on one of the special exemptions for foreign private issuers (such as the board of auditors exemption) discussed in Section G below. However, the special exemptions available to the foreign parent are not available to its U.S. subsidiary. Fried, Frank, Harris, Shriver & Jacobson
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SEC Adopts Audit Committee Standards for Listed Companies
c. Trusts or Unincorporated Associations. The listing of securities of a listed issuer is not subject to the audit committee requirements if the listed issuer is organized as a trust or other unincorporated association that does not have a board of directors or persons acting in a similar capacity and the activities of the listed issuer are limited to the passive ownership or holding (as well as administering and distributing amounts in respect of) of securities, rights, collateral or other assets on behalf of or for the benefit of holders of the listed securities. d. Reasons Outside Director's Control. The SEC's rules also allow an SRO's rules to provide that, if a member of an audit committee ceases to be independent in accordance with the SEC rules for reasons outside the member's reasonable control, that person, with notice by the issuer to the applicable SRO, may remain an audit committee member of the issuer until the earlier of the next annual shareholders' meeting of the issuer or one year from the occurrence of the event that caused the member to be no longer independent. 3. Board of Directors as the Audit Committee The SEC permits an issuer with listed securities either to designate a separate audit committee or have the entire board of directors perform the functions of an audit committee. If the entire board constitutes the audit committee, the new SRO rules, including the audit committee independence requirements, will apply to the issuer's board as a whole. In the case of a listed issuer that is a limited partnership or limited liability company, where such entity does not have a board of directors or equivalent body, the term "board of directors" means the board of directors of the managing general partner, managing member or equivalent body. G. Foreign Private Issuers The SEC has adopted a number of exemptions specifically for foreign private issuers. The SEC's adopting release states that, other than as set forth in the SEC's rules described below, an SRO may not exempt foreign issuers from the audit committee requirements or grant waivers. The SEC does state that the staff will continue to remain sensitive to evolving standards of corporate governance throughout the world to address any new conflicts that may arise with foreign corporate governance rules and practices.
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April 24, 2003
SEC Adopts Audit Committee Standards for Listed Companies 1. Independence Tests The SEC included several additional exemptions governing audit committee independence that are available to foreign private issuers. a. Non-executive employees. Employees of a foreign private issuer who are not executive officers are exempt from both the "affiliated person" and the "no compensatory payment" requirements, and may sit on the audit committee of a foreign private issuer, provided that the employee is elected or named to the board of directors or audit committee of the foreign private issuer pursuant to the issuer's governing law or documents, an employee collective bargaining agreement or similar agreement or other home country legal or listing requirements. This exemption is particularly relevant for companies in countries such as Germany, where non-management employees, who would not be viewed as "independent" under the requirements, are required to serve on the supervisory board or audit committee. b. Controlling Shareholder. Any audit committee member of a foreign private issuer can be an affiliate of the foreign private issuer or a representative of such affiliate, if (1) the "no compensation" prong of the independence requirements is satisfied, (2) the member has only observer status on, and is not a voting member or the chair of, the audit committee, and (3) neither the member nor the affiliate is an executive officer of the foreign private issuer. As proposed, this exemption would have only been applicable to one member of the committee. c. Governmental Representation. Any audit committee member of a foreign private issuer can be a representative or designee of a foreign government or foreign governmental entity that is an affiliate of a foreign private issuer, if the "no compensation" prong of the independence requirement is satisfied and the member in question is not an executive officer of the foreign private issuer. 4 As proposed, this exemption would have only been applied to one member of the committee.
4 The SEC acknowledged that foreign governments hold interests in foreign private issuers in a variety of ways, including directly, through branches or agencies, through institutions organized under public law and otherwise. The SEC clarified that the exemption applies regardless of the manner in which the foreign government owns its interest. Fried, Frank, Harris, Shriver & Jacobson 10 April 24, 2003
SEC Adopts Audit Committee Standards for Listed Companies 2. Boards of Auditors The listing of securities of a foreign private issuer is also exempt from all of the audit committee requirements if all of the following requirements relating to the existence of a board of auditors are met: • the foreign private issuer has a board of auditors (or similar body), or has statutory auditors, established and selected pursuant to home country legal or listing provisions expressly requiring or permitting such a board or similar body; • the board of auditors or statutory auditor is required under home country legal or listing requirements to be either (A) separate from the board of directors or (B) composed of one or more members of the board of directors and one or more members that are not also members of the board of directors; • the board of auditors is not elected by management of the issuer and no executive officer of the issuer is a member of the board of auditors; • home country legal or listing provisions set forth or provide for standards for the independence of the board of auditors from the issuer or the management of the issuer; • the board of auditors, in accordance with any applicable home country legal or listing requirements or the issuer's governing documents, is responsible, to the extent permitted by law, for the appointment, retention and oversight of the work of any registered public accounting firm engaged (including, to the extent permitted by law, the resolution of disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the issuer; and • the audit committee requirements relating to complaint procedures, retention of advisors and funding apply to the board of auditors, to the extent permitted by law.
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