Table of Contents On December 14, 1999, the Securities and Exchange Commission (the "Commission") approved changes to the rules of the New York Stock Exchange (the "Exchange") with respect to audit committees (Release No. 34-42233; File No. SR-NYSE-99-39). Pursuant to the new Exchange rules, each company must now have a qualified audit committee (see Sections VI through VIII hereof for Exchange requirements). On December 22, 1999, the Commission adopted new rules and amendments to current rules with respect to the functioning of audit committees (Release No. 34-42266; File No. S7-22-99) (see Sections I through V hereof for Commission requirements). I. Review of Interim Financial Statements The Commission has amended Rule 10-01(d) of Regulation S-X and Item 310(b) of Regulation S-B to require that interim financial statements be reviewed by an independent public accountant prior to the company's Form 10-Q or 10-QSB filing. It is not required that interim statements be audited. The amendment requires that independent public accountants follow professional standards and procedures for conducting such reviews, as established by generally accepted auditing standards. Under current auditing standards this means that auditors would be required to follow the procedures set forth in SAS 71 (which provides guidelines to independent accountants on performing reviews of interim financial information) or such other auditing standards that may, in time, modify, supplement or replace SAS 71. If, in any filing, the company states that interim financial statements have been so reviewed, a report of the independent public accountant must be filed with the interim statements. The Commission noted that the five largest U.S. accounting firms have recently required reviews of quarterly statements as a condition to acceptance of an audit. Consequently, those firms have already implemented this condition for companies they audit. Additionally, the Commission has amended Item 302(a) of Regulation S-K to extend the requirement that companies supplement their annual financial information with disclosures of selected quarterly data, such as net sales and gross profit for the prior two years, to all companies that have securities registered under Sections 12(b) or 12(g) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), regardless of the size of the company or public float. This requirement does not extend to small business issuers filing on small business forms. The Commission has adopted a new Item 306 to Regulations S-K and S-B and Item 7(e)(3) to Schedule 14A. Under these new rules, an audit committee is required to provide a report in the company's proxy statement. In the report, the committee is required to state whether it: (1) reviewed and discussed the audited financial statements with management; (2) discussed with the company's independent auditors the matters required to be discussed by SAS 61 (which requires auditors to communicate the result of an audit and to discuss the same with a public company's audit committee); and (3) received the written disclosures and the letter from the company's independent auditors required by ISB Standard No.1 (which sets out the standards for independence of auditors of a public company), and has discussed the auditors' independence with the auditors. In addition, paragraph (a)(4) to Item 306 requires the audit committee to state whether, based on the review and discussions referred to above, it recommended to the Board of Directors that the financial statements be included in the Annual Report on Form 10-K or 10-KSB for the last fiscal year for filing with the Commission. This requirement is intended to serve the purpose of providing investors with a better understanding of the audit committee's oversight role in the financial reporting process. The audit committee's recommendation that the financial statements be used in Commission filings is implicit in, and is consistent with, board members signing the company's Annual Report on Form 10-K or 10-KSB. In performing its oversight function, the audit committee likely will be relying on advice and information that it receives in its discussions with management and the independent auditors, and, based on those discussions, make decisions about the financial statements and the filing of the company's Form 10-K or Form 10-KSB. This approach is consistent with state corporation law that permits board members to rely on the representations of management and the opinions of experts when reaching business judgments. The Commission stated that the more informed the audit committee becomes through its discussions with management and independent auditors, the more likely that the "business judgment rule" will apply. The report is required to appear over the printed names of each member of the audit committee. The Commission stated that it believes the foregoing would reinforce the audit committee's awareness and acceptance of its responsibilities. III. Audit Committee Charter Disclosure The Commission has adopted a requirement that a company disclose in its proxy statements whether its audit committee is governed by a charter (see Section VI, below) and, if so, a copy of the charter is to be included as an appendix thereto at least once every three years. The new requirement appears as new paragraph (e)(3) of Item 7 of Schedule 14A. The Commission stated that the new disclosure should help shareholders assess the role and responsibilities of the committee and help focus the committee on its responsibilities as expressed in the charter. IV. Disclosure Regarding Independence of Audit Committee Members The Commission has adopted the requirement that companies whose securities are listed on the NYSE or AMEX or quoted on the Nasdaq that have a non-independent audit committee member disclose the nature of the relationship that makes that individual not independent and the reasons for the Board's determination to appoint the director to the audit committee. These rules do not apply to small businesses. The Commission has adopted safe harbors to cover the new disclosures. The safe harbors track the treatment of compensation committee reports under Item 402 of Regulation S-K and appear in proposed paragraph (c) in new Item 306 to Regulations S-K and S-B and in adopted paragraph (e)(v) to Schedule 14A. Under the safe harbors, the disclosure called for by the proposals will not be considered "soliciting material" "filed" with the Commission, subject to Regulation 14A or 14C or to the liabilities of Section 18 of the Exchange Act. A Board of Directors of an Exchange listed company must adopt and approve a formal written charter for its audit committee, and the audit committee must review and reassess the adequacy of its charter on an annual basis. The charter must specify the following: a) the scope of the audit committee's responsibilities and how it carries out those responsibilities, including structure, processes and membership requirements; b) that the outside auditor for the company is ultimately accountable to the Board of Directors and audit committee, that the audit committee and Board of Directors have the ultimate authority and responsibility to select, evaluate and, where appropriate, replace the outside auditor (or to nominate the outside auditor to be proposed for shareholder approval in any proxy statement); and c) that the audit committee is responsible for ensuring that the outside auditor submits on a periodic basis to the audit committee a formal written statement delineating all relationships between the auditor and the company, and that the audit committee is responsible for actively engaging in a dialogue with the outside auditor with respect to any disclosed relationships or services that may impact the objectivity and independence of the outside auditor and for recommending that the Board of Directors take appropriate action in response to the outside auditors' report to satisfy itself of the outside auditors' independence.
Each audit committee of an Exchange listed company must consist of at least three directors, all of whom have no relationship to the company that may interfere with the exercise of their independence from management and the company, i.e., an audit committee member must be "independent." In addition to the definition of "independent" provided above, the following restrictions apply to every audit committee member. Employees. A director who is an employee (including non-employee executive officers) of the company or any of its affiliates may not serve on the audit committee until three years following the termination of his or her employment. In the event the employment relationship is with a former parent or predecessor of the company, the director could serve on the audit committee after three years following the termination of the relationship between the company and the former parent or predecessor. Business Relationship. A director: a) who is a partner, controlling shareholder, or executive officer of an organization that has a business relationship1 with the company, or b) who has a direct business relationship with the company (e.g., a consultant), may serve on the audit committee only if the company's Board of Directors determines in its business judgment that the relationship does not interfere with the director's exercise of independent judgment. In making such a determination regarding the independence of a director, the Board of Directors should consider, among other things, the materiality of the relationship to the company, to the director, and, if applicable, to the organization with which the director is affiliated. Such a director may serve on the audit committee without such Board determination after three years following the termination of: a) the relationship between the organization with which the director is affiliated and the company; b) the relationship between the director and his or her partnership status, shareholder interest or executive officer position; or c) the direct business relationship between the director and the company.
Immediate Family. A director who is an "immediate family" member of an individual who is an executive officer of the company or any of its affiliates cannot serve on the audit committee until three years following the termination of such employment relationship. Exceptional Circumstance Exception to the Independence Requirement. Notwithstanding the requirements with respect to the independence of employees and immediate family members, one director who is no longer an employee or who is an immediate family member of a former executive officer of the company or its affiliates, but is not considered independent pursuant to the above-mentioned provisions due to the three-year restriction period, may be appointed, under exceptional and limited circumstances, to the audit committee if: a) the company's Board of Directors determines in its business judgment that membership on the audit committee by the individual is required by the best interests of the corporation and its shareholders; and b) the company discloses, in the next annual proxy statement subsequent to such determination, the nature of the relationship and the reasons for that determination. Qualifications. Under Exchange Rule 303.01(B)(2)(b) and (c), each member of the audit committee must be financially literate, as such qualification is interpreted by the company's Board of Directors in its business judgment, or must become financially literate within a reasonable period of time after his or her appointment to the audit committee. In addition, at least one member of the audit committee must have accounting or related financial management expertise, as the Board of Directors interprets such qualification in its business judgment.
Other Definitions "Immediate family" includes a person's spouse, parents, children, siblings, mothers-in-law and fathers-in-law, sons and daughters-in-law, brothers and sisters-in-law, and anyone (other than employees) who shares such person's home. "Affiliate" includes a subsidiary, sibling company, predecessor, parent company, or former parent company. "Officer" has the meaning specified in Rule 16a-1(f) under the Exchange Act. Written Affirmation As part of the initial listing process, and with respect to any subsequent changes to the composition of the audit committee, and otherwise approximately once each year, each company should provide the Exchange written confirmation regarding: b) the financial literacy of the audit committee members; c) the determination that at least one of the audit committee members has accounting or related financial management expertise; and d) the annual review and reassessment of the adequacy of the audit committee charter. Initial Public Offering. Companies listing in conjunction with their initial public offering (including spin-offs and carve outs) will be required to have two qualified audit committee members in place within three months of listing and a third qualified member in place within twelve months of listing. The Commission's rule changes go into effect on January 31, 2000, and registrants must obtain reviews of interim financial information by their independent auditors starting with their Forms 10-Q to be filed for fiscal quarters ending on or after March 15, 2000. Registrants must comply with the new proxy and information disclosure requirements for all proxy and information statements relating to votes of shareholders occurring after December 15, 2000. Companies may voluntarily comply with the new requirements prior to the compliance dates. The Exchange provided for a transition period in order to give issuers sufficient time to comply with its rule changes. Specifically, the Exchange has: a) "grandfathered" all public company audit committee members qualified under current Exchange rules until they are re-elected or replaced; and b) given companies that have less than three members on their audit committees eighteen months from December 14, 1999, to recruit the requisite members. Issuers with securities listed on the Exchange, as of December 14, 1999, will have six months to adopt a formal written audit committee charter.
Michael F. Fitzpatrick, Jr. Michael V. Bonacorsa
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Audit Committee Disclosure
This article was edited and reviewed by FindLaw Attorney Writers | Last reviewed March 26, 2008
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