As required by Section 301 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission adopted final rules on April 9, 2003 directing the national securities exchanges and associations (principally the NYSE, AMEX and Nasdaq) to prohibit the listing of any security of a company that is not in compliance with the audit committee requirements established by the Sarbanes-Oxley Act. The SEC had previously issued proposed rules on January 9, 2003, which were summarized in our Public Company Advisory entitled "SEC Proposes Rules Requiring Listing Standards for Audit Committee Independence and Powers." A copy of the final rules can be found at http://www.sec.gov/rules/final/33-8220.htm.
As discussed in greater detail below, the SEC rules require the national securities exchanges and associations to adopt final rules that comply with the SEC rules no later than December 1, 2003, with effectiveness in 2004.
Summary of Requirements
In general, self-regulatory organizations (SROs) such as the NYSE, AMEX and Nasdaq will be prohibited from listing any security of a company that does not comply with the following standards:
- each member of the audit committee must be independent under specified narrow criteria;
- the audit committee must be directly responsible for the appointment, compensation, retention and oversight of the work of the company's independent auditor, and the independent auditor must report directly to the audit committee;
- the audit committee must have authority and appropriate funding to engage any independent advisors and consultants, including legal counsel, that it determines are necessary to carry out its duties; and
- the audit committee must establish procedures for the treatment of complaints regarding accounting, internal accounting controls or auditing matters, including procedures for confidential and anonymous submission of complaints by employees of concerns regarding questionable accounting or auditing matters.
In addition, the final rules adopt several changes to existing disclosure requirements regarding audit committees. The SEC reiterated in its release that SROs are not precluded from adopting additional listing standards regarding audit committees, as long as they are consistent with the SEC rules, and it has encouraged them to adopt "rigorous" requirements. During 2002, the NYSE and Nasdaq filed sweeping amendments to their listing standards for SEC approval. Those proposals, which extend significantly beyond the scope of the final SEC rules under Section 301 of the Sarbanes-Oxley Act, have been recently amended and remain pending before the SEC.
Timing for Implementation of New Listing Standards
Under the final rules, each SRO must file proposed rules or rule amendments that comply with the final SEC rules no later than July 15, 2003 and must have final rules or rule amendments approved by the SEC no later than December 1, 2003. Listed companies, other than foreign private issuers and small business issuers, must be in compliance with the new listing rules by the earlier of (i) their first annual shareholders meeting after January 15, 2004 or (ii) October 31, 2004. Foreign private issuers and small business issuers that are listed must be in compliance by July 31, 2005.
In addition, companies must comply with the new disclosure rules beginning with reports covering periods ending on or after (or proxy or information statements for actions occurring on or after) the applicable compliance date set forth above. Until that time, companies should continue to comply with the disclosure requirements of existing rules.
Companies Affected by the New Rules
The SEC rules relating to independence apply to domestic companies (including small business issuers), foreign private issuers, closed-end investment companies and exchange-traded open-end investment companies that have securities listed on a national securities exchange (such as the NYSE or AMEX) or on the Nasdaq National Market or SmallCap Market. The rules do not apply to companies whose securities are quoted on the OTC Bulletin Board (OTCBB), the Pink Sheets or the Yellow Sheets, unless their securities are also listed on an exchange or NASDAQ, nor will they apply to unit investment trusts or issuers of asset-backed securities.
The amended disclosure rules generally apply to all reporting companies, including non-listed issuers. Certain exemptions and variations apply to specific issuers such as unit investment trusts, asset-backed issuers and foreign private issuers.
Audit Committee Member Independence
The final rules enhance audit committee independence by implementing the following two basic criteria for determining audit committee member independence.
No Compensatory Fees. First, audit committee members may not accept, directly or indirectly, any consulting, advisory or other compensatory fees from the company or any subsidiary of the company, other than for service as a member of the board of directors and any board committee. This prohibition will preclude payments to a member as an officer or employee. The SEC expressly declined to include a de minimus exception.
In response to comments, the SEC clarified in the final rules that, unless an SRO's listing rules provide otherwise, compensatory fees do not include the receipt of fixed amounts of compensation under a retirement plan (including deferred compensation) for prior service with the company (provided that the compensation is not contingent in any way on continued service). In addition, the release made clear that the receipt of dividends or other payments by a committee member who is a shareholder is not prohibited if the payments are made to all shareholders of a class generally.
"Indirect" compensatory payments include payments to spouses, minor children or stepchildren, or children or stepchildren sharing a home with the member. In addition, indirect payments include those made to an entity in which the audit committee member is a partner, member, an officer such as a managing director occupying a comparable position or executive officer, or occupies a similar position (but not limited partners, non-managing members and those occupying similar positions who, in each case, have no active role in providing services to the entity) and which provides accounting, consulting, legal, investment banking or financial advisory services to the company or any of its subsidiaries. Other commercial relationships are not covered by the final rule, although the SEC expects that SROs will include additional restrictions in their listing standards.
The SEC's final rules apply the prohibitions only to current relationships with the audit committee member and related persons, although the SEC expects the SROs to require "look-back" periods in their revised listing standards.
No Affiliated Persons. Second, a member of the audit committee of a company that is not an investment company may not be an affiliated person of the company or any subsidiary of the company apart from his or her capacity as a member of the board and any board committee of the company. A person who directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, another person is an "affiliate" of such other person. "Control" is defined consistently with the SEC's definition under the Exchange Act 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." The SEC's rules specifically provide that an executive officer, a director who is also an employee, a general partner or a managing member of an entity that is an affiliate of the company will be deemed to be an affiliate of the company for purposes of the audit committee independence rules.
The SEC adopted a safe harbor from the definition of "affiliated person" for non-investment companies. Under the safe harbor, a person who is not an executive officer or the direct or indirect beneficial owner of 10% or more of any class of voting equity securities of the company or of an entity that is an affiliate of the company will be deemed not to control the company and therefore would not be an affiliated person. The SEC emphasized in its release that the safe harbor identifies a group of persons who are not affiliates, but that failure to obtain the safe harbor has no bearing on whether a particular person is an affiliate based on an evaluation of all facts and circumstances. Accordingly, a director who is not an executive officer but beneficially owns more than 10% of the company's voting equity securities could be determined to not be an affiliate under a facts and circumstances analysis of control.
The rules adopted with respect to investment companies differ in certain respects. A member of the audit committee of an investment company may not be an "interested person" of the investment company as defined in the Investment Company Act.
Exemptions. The Sarbanes-Oxley Act permits the SEC to exempt particular relationships from the independence requirements, if appropriate. Although the final rules contain limited exemptions (summarized below), it is important to note that the final rules eliminate the "exceptional and limited circumstances" exemptions that exist currently under several SRO rules. In addition, the SEC's rules will not permit SROs to grant exemptions or waivers for particular relationships on a case-by-case basis. The final rules contained only the following exemptions, each of which was modified from the original proposal:
- Newly-Listed Companies. Non-investment companies will be required to have at least one fully independent member at the time of its initial listing, a majority of independent members within 90 days, and a fully independent committee within one year; and
- Overlapping Board Relationships. An audit committee member that serves on the board of directors of both a listed company and an affiliate of the company is exempt from the "affiliated person" prohibition if the committee member otherwise meets the independence requirements for both the listed company and the affiliate, including receiving only ordinary-course compensation for serving as a member of the board of directors, audit committee or any other board committee of the listed company and the affiliate.
In addition, the SEC rules provide other limited exemptions from the independence requirements for controlling persons, foreign governmental board representatives and non-management employee members of foreign private issuers.
Audit Committee Powers
Powers Relating to the Company's Auditors. Under the SEC's final rules, the SROs must require each listed company to have an audit committee that is directly responsible for the appointment, compensation, retention and oversight of the work of the company's independent auditor engaged (including 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 company, and the independent auditor must report directly to the audit committee. The audit committee must have authority to retain and terminate the outside auditor and to approve all audit engagement fees and terms, as well as all significant non-audit engagements of the independent auditor.
The SEC had proposed exempting investment companies from the requirement that the audit committee be responsible for the selection of the independent auditor because the Investment Company Act already requires that the disinterested directors select the auditors. However, as a result of the January 2003 amendments to the auditor independence requirements, the SEC elected not to adopt this exemption.
Power to Engage Independent Consultants and Counsel. The final SEC rules provide that the SROs specifically require audit committees to have the authority to engage any outside consultants and advisors, including independent counsel, as the audit committee determines are necessary to carry out its duties.
Funding. SROs must require each listed company to provide appropriate funding, as determined by the audit committee, for the payment of:
- compensation to independent auditors;
- compensation to outside consultants, advisors and counsel; and
- ordinary administrative expenses of the audit committee that are necessary or appropriate in carrying out its duties.
Procedures for Handling Complaints
As proposed, the SEC's final rules provide that the SROs must require each listed company's audit committee to establish procedures for:
- the receipt, retention and treatment of complaints received by the company regarding accounting, internal accounting controls or auditing matters; and
- the confidential and anonymous submission by employees of the company of concerns regarding questionable accounting or auditing matters.
The SEC expressly declined to mandate specific procedures that an audit committee must establish. As a result, companies will be required to develop procedures appropriate for their circumstances.
Disclosure Regarding Exemptions. As proposed, the final rules require that a company relying on one of the exemptions from the independence standards discussed above must disclose its reliance on the exemption and its assessment of whether, and if so, how, such reliance would materially adversely affect the ability of its audit committee to act independently and to satisfy the other requirements of the rules. The disclosure must appear in, or be incorporated by reference into, annual reports filed with the SEC, as well as in proxy statements or information statements for shareholders' meetings at which elections for directors are held.
Identification of the Audit Committee. Currently, a company subject to SEC proxy rules is required to disclose in its proxy statement whether the company has a standing audit committee, the names of each committee member, the number of committee meetings held by the audit committee during the last fiscal year and the functions performed by the committee. The SEC adopted as proposed a requirement that disclosure of the members of the audit committee be included or incorporated by reference in the listed company's annual report filed with the SEC.
Compliance and Opportunity to Cure Defects The Sarbanes-Oxley Act did not establish mechanisms for SROs to ensure compliance with the listing standards. Instead, the SEC's rules direct the SROs to require a listed company to notify the applicable SRO promptly after an executive officer of the company becomes aware of any material noncompliance by the company with the requirements.
The Sarbanes-Oxley Act specifies that the final SRO listing standards must provide for appropriate procedures for a company to have an opportunity to cure any defects that would be the basis for a prohibition of the listing of the company's securities as a result of its failure to meet the standards. Accordingly, the final SEC rules require the SROs to provide appropriate procedures before they prohibit the listing of or delist any security of a company for this reason. The SEC again indicated that existing continued listing or maintenance standards and delisting procedures of the SROs would suffice as procedures for a company to have an opportunity to cure any defects because they already provide listed companies with notice and opportunity for a hearing, an opportunity for an appeal and an opportunity to cure any defects before their securities are delisted. However, the SEC expects that the final rules of each SRO will provide for definite procedures and time periods for compliance to the extent they do not already do so.
In addition, the final SEC rules provide that the SRO rules may provide that if a member of an audit committee ceases to be independent for reasons outside the member's reasonable control, that member, with notice by the company to the applicable SRO, may remain an audit committee member until the next annual shareholders meeting or one year from the occurrence of the event that caused the member to be no longer independent, whichever occurs first.
As proposed, the SEC adopted an exemption from the requirements for additional listings of securities by a company when the company is subject to the requirements as a result of the listing of a class of securities. The additional listings could be on the same market or on different markets. The SEC also extended this exemption to listings of non-equity securities (as well as non-convertible, non-participating preferred securities such as trust-preferred securities) by a direct or indirect consolidated subsidiary or an at least 50% beneficially owned subsidiary of a parent company, if the parent company is subject to the requirements as a result of the listing of a class of its common equity securities.
The Corporate Governance, Securities Litigation and M&A attorneys at Goodwin Procter keep current on these matters. We are available to help advise public companies and their officers and directors on specific issues as well as to provide educational presentations to help them understand and meet their responsibilities under both current and proposed rules and regulations. Please contact us either directly or through your regular Goodwin Procter contact if we may be of assistance.