On October 8, 1999, the Securities and Exchange Commission (the "SEC"), in Securities Exchange Act of 1934 Release Number 34-41987 (the "SEC Release"), proposed certain new rules and amendments to existing rules relating to corporate audit committees and the financial statements of public companies.
I. Background
According to the SEC Release, these proposed rules and rule amendments are designed to improve disclosure relating to the functioning of corporate audit committees and to enhance the reliability and credibility of financial statements of public companies. In proposing these new rules and rule amendments, the SEC recognizes that accurate and reliable financial reporting is the foundation of the disclosure-based system of securities regulation. Moreover, the SEC Release acknowledges that in today's high tech, high speed information society, investors need accurate and reliable financial information to make informed investment decisions.
The SEC Release notes that investors often react quickly to quarterly results, yet quarterly financial reporting has never been subject to the same discipline that is applied to annual financial reporting. It is commonplace for financial analysts to set quarterly earnings expectations, and the consequences of a company failing to meet or exceed such expectations may be a precipitous decline in its stock price. A recent SEC theme is that companies are experiencing increasing pressure to "manage" interim financial results, and that inappropriate earnings management may be deterred by imposing more discipline on the process of preparing interim financial information.
In proposing these changes, the SEC explains that effective oversight of the financial reporting process is fundamental to preserving the integrity of securities markets. Moreover, in the view of the SEC, audit committees can, and should, be the corporate participant best able to perform that oversight function. Thus, the proposed rules and rule amendments focus on (1) increasing independent auditors' roles in the disclosure process; and (2) requiring audit committees to disclose more detailed information. Specifically, the SEC Release proposes rules and rule amendments relating to five distinct topics. Each of these topics is summarized below.
II. Summary of Proposed Rule Changes and Amendments
According to the SEC Release, the requirement that the audit committee state that "nothing came to the attention of the audit committee members," is intended to encourage audit committees to "ask tough questions of management and outside auditors" to serve the interests of investors. Noting that directors may be concerned that a report from the audit committee will result in increased liability exposure for audit committee members, the SEC Release states that directors will be better insulated from liability through more informed discussions with management and auditors. This paradoxical theory appears to be that because directors will be required to make an affirmative statement that nothing has come to their attention, such directors will effectively go the extra mile to make sure that they really do know of nothing which should be disclosed; and thus, they will be better insulated from liability. Whether the SEC's view about such liability will be supported by the outcome of future stockholder litigation, however, remains to be seen.
Third, the proposed rule changes and rule amendments would require that a public company disclose in its proxy statements whether its audit committee was governed by a charter. Further, under the proposed rules, if such a charter exists, the company would be required to include a copy of the charter as an appendix to its proxy statement at least once every three years. The SEC Release reasons that such disclosure will help stockholders assess the role and responsibilities of the audit committee. The proposed rules do not, however, require companies to adopt audit committee charters, nor do they require any particular statement about whether the audit committee has complied with the charter. If this proposal is adopted, however, there may be an increased expectation that charters exist for audit committees of public companies. In addition, as described in more detail below, the American Stock Exchange ("AMEX"), the New York Stock Exchange ("NYSE") and the NASD have each recently proposed rules requiring such a charter.
Fourth, the proposed rule changes and rule amendments would require that companies whose securities are quoted on Nasdaq or listed on AMEX or NYSE 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. NYSE, AMEX and the NASD have each proposed amendments to their respective listing standards requiring that all audit committee members be "independent," with a limited exception for one director if certain criteria are met. These proposed rule changes generally include: (1) a more demanding definition of "independence" for audit committee members; (2) a requirement that audit committees include at least three members, comprised solely of "independent" directors who are financially literate, with limited exceptions; (3) a requirement that at least one member of the audit committee have accounting or related financial management expertise; and (4) a requirement that companies adopt a written audit committee charter that outlines certain specified responsibilities of the audit committee.
As noted above, the NYSE, AMEX, and NASD proposals regarding independence of audit committee members are each subject to the same limited exception. Specifically, pursuant to each of these proposals, under exceptional and limited circumstances, one director who is not independent may be appointed to the audit committee, but only if: (1) the Board determines that membership on the committee by the individual is required by the best interests of the corporation and its shareholders, and (2) the Board discloses, in the next annual proxy statement subsequent to such determination, the nature of the relationship and the reasons for that determination.
The SEC is also proposing rule changes and rule amendments which would require that all other companies, including small business issuers, disclose in their proxy statements whether, if they have an audit committee, the members are "independent" within the definition of any of the above standards. Such companies will, however, be required to disclose which standard they have applied.
Finally, the proposed rule changes and rule amendments would create "safe harbors" for the information required to be disclosed under the proposals to protect companies and their directors from certain liabilities under the federal securities laws. Specifically, the "safe harbors" would track the treatment of compensation committee reports under Item 402 of Regulation S- K. In particular, the additional disclosure would not be considered "soliciting," "filed" with the Commission, subject to Regulation 14A or 14C or to the liabilities of Section 18 of the Exchange Act, except to the extent that the company specifically requests that it be treated as soliciting material, or specifically incorporates it by reference into a document filed under the Securities Act or the Exchange Act.
III. Conclusion
Consistent with SEC practice, the foregoing proposed rules and rule amendments have not yet been finalized. The SEC Release requests comments on a large number of issues relating to these proposals. Accordingly, these proposals may undergo significant revisions. Notwithstanding the foregoing, it can be anticipated that final rules will be adopted bearing some resemblance to the proposals described above. Thus, companies may wish to begin their planning for next year's annual stockholders' meetings and the composition of their committees by evaluating the independence of the members of their audit committees, the charters of their committees, the manner in which the audit committee members interact with management and outside auditors and the interim review of their quarterly financial statements. Saul Ewing will continue to keep you advised of future developments in this area. Please let us know if you would like a copy of the full SEC Release. You may also obtain the full text by visiting the SEC's website at http://www.sec.gov/rules/proposed/34-41987.htm
This Update was prepared by David S. Antzis and Andrew P. Sutor, IV, members of Saul Ewing's Business Department. If you would like more information on this please contact Mr. Antzis at (610) 251-5055 or at dantzis@saul.com, or Mr. Sutor at (215) 972-8560 or at asutor@saul.com.
Note: Posted articles are for general information only and should not be considered legal advice.