During December, the Securities and Exchange Commission published new rules relating to the operations of audit committees and outside auditors of public companies. The SEC also approved related changes to the rules governing companies with securities traded on the New York Stock Exchange, the American Stock Exchange and the Nasdaq Stock Market .
Summary of SEC Rule Changes
The new SEC rules require that:
- A company's independent auditors review the financial information included in its quarterly reports on Forms 10-Q or 10-QSB before they are filed with the Commission;
- A company's proxy statements include a report of its audit committee, stating:
- (i) whether the committee has reviewed and discussed the audited financial statements with management,
- (ii) whether the committee has discussed with the independent auditors certain matters required to be discussed under Statement on Auditing Standards (SAS) 61,
- (iii) whether the committee has received certain required disclosures from the auditors regarding the auditors' independence, and discussed the auditors' independence with them, and
- (iv) that, based on the review and discussions referred to above, the committee has recommended to the full Board of Directors that the audited financial statements be included in the company's annual report on Form 10-K or 10-KSB;
- A company's proxy statement disclose whether its audit committee has adopted a written charter and include a copy of the charter as an appendix to the proxy statement at least once every three years;
- Companies whose securities are quoted on Nasdaq or listed on the NYSE or the AMEX disclose in their proxy statements certain information regarding any director on the audit committee who is not "independent," as defined in the applicable listing standard (small business issuers will be exempt from this requirement); and
- All other companies, including small business issuers, disclose in their proxy statements whether, if they have an audit committee, the members are "independent" for this purpose, the company is to select a definition of "independent" from either the Nasdaq's, the NYSE's or the AMEX's recent amendments to their listing standards defining independence.
The SEC rule changes create certain "safe harbors" for the new audit committee disclosures, which track the SEC's treatment of compensation committee reports contained in proxy statements. Under the "safe harbors," the new disclosures will not be considered "soliciting material" "Filed" with the Commission, unless the company specifically requests different treatment. The intent of the "safe harbors" is to protect companies and their directors from certain liabilities under the federal securities laws.
The SEC also expanded the number of companies that are required to disclose selected quarterly financial data along with their annual financial information. Under the revised rules, only small companies that fit the definition of "small business issuers" filing under Regulation SB will be exempt from this Regulation S-K, Item 302(a) requirement.
The new proxy statement disclosure requirements generally do not take effect until the 2001 proxy season, which should give most companies ample time to educate committee members, address the new "independence" rules, and take other steps to ensure that the newly mandated disclosures will not cast the company in an unflattering light. The new rules on independent auditor review of quarterly financial information take effect sooner, during the first quarter of 2000. The expanded applicability of S-K 302(a) begins after December 15, 2000.
Summary of NYSE, AMEX and Nasdaq Rule Changes
The rule changes for the NYSE, AMEX and Nasdaq include:
- adoption of a new, more demanding, definition of "independence" for audit committee members (described further below),
- a requirement that each listed company have an audit committee with at least three directors, each of whom is independent and financially literate, although the committee may have one non-independent member under certain exceptional and limited circumstances (the Nasdaq and AMEX rules permit small business issuers filing under Regulation S-B to have only two audit committee members),
- a requirement that at least one member of the audit committee have accounting or related financial management expertise (this requirement does not apply to small business issuers under the Nasdaq and AMEX rules), and
- a requirement that companies adopt a written audit committee charter that outlines specified responsibilities of the audit committee.
In addition, the NYSE and the AMEX require regular written confirmation to the Exchange regarding certain matters relating to the qualification of the audit committee and adherence to the new procedures.
The NYSE now defines directors as "independent" if they have no relationship to the company that may interfere with the exercise of their independence from management and the company. In addition, the NYSE rules restrict audit committee service by employees (for three years after their employment ends), persons with certain cross compensation committee links, and immediate family members of persons who are (or were in the past three years) executive officers of the company or any of its affiliates. A director who is a partner, controlling shareholder, or executive officer of an organization that has a business relationship with the company, or who has a direct business relationship with the company (e.g., a consultant) may serve on the audit committee only if the full board determines in its business judgment that the relationship does not interfere with the director's exercise of independent judgment.
The Nasdaq and AMEX rules on independence are similar, although they specify thresholds above which a business relationship is deemed to interfere with independence. Thus, a director who accepts compensation from the company or an affiliate in excess of $60,000 during the prior fiscal year (other than compensation for board service, benefits under a tax-qualified retirement plan, or non-discretionary compensation) will not be considered independent by Nasdaq or the AMEX. Similarly, a director who is a partner, controlling shareholder, or executive officer of a for-profit business organization to which the company made, or from which the company received, payments (except those arising solely from investments in the company's securities) that exceed 5% of the company's or the business organization's consolidated gross revenues for the year, or $200,000, whichever is more, in any of the past three years, also will not be considered independent under the Nasdaq or AMEX rules.
Issuers currently listed on the NYSE, AMEX or Nasdaq will have six months (until June 2000) to meet the new requirement for a written audit committee charter. AMEX and Nasdaq issuers will have 18 months (until June 2001) to meet the audit committee structure and membership requirements. The NYSE will give companies with less than three members on their audit committees 18 months to recruit additional members. However, NYSE-listed companies will not have 18 months to implement the new audit committee independence and financial literacy requirements. The NYSE will "grandfather" public company audit committee members qualified under current NYSE rules only until they are re-elected or replaced (which in most companies will occur in conjunction with the next annual meeting). Newly-listed companies and companies switching exchanges will be subject to special phase-in rules which differ, depending on the exchange. For most companies, the SEC's new proxy statement disclosure requirements will become effective before June 2001, when the NYSE, AMEX and Nasdaq rule changes will be fully phased-in. Companies should keep this timing consideration in mind when selecting director nominees and audit committee members.