As required by Section 301 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission proposed new rules on January 9, 2003 directing the national securities exchanges and associations (principally the NYSE, AMEX and Nasdaq) to prohibit the listing of any equity or debt security of a company that is not in compliance with the audit committee requirements established by the Sarbanes-Oxley Act.
Summary of New Requirements
In general, self-regulatory organizations (SROs) such as the NYSE, AMEX and Nasdaq would 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.
In addition, the SEC proposed several changes to existing disclosure requirements regarding audit committees. The SEC expressly stated in its proposal that SROs are not precluded from adopting additional listing standards regarding audit committees, as long as they are consistent with the proposed SEC rules. During 2002, the NYSE and Nasdaq filed sweeping amendments to their listing standards for SEC approval. These proposed amendments, which extend significantly beyond the scope of the requirements of the current SEC proposal, remain pending before the SEC.
Timing for Implementation of New Listing Standards
The Sarbanes-Oxley Act requires the SEC to adopt these rules, which are subject to a 30-day public comment period, not later than April 26, 2003. Under the SEC's proposal, each SRO must file proposed rules or amendments that comply with the final SEC rules no later than 60 days after publication of the SEC's final rules in the Federal Register, and must have adopted final rules or amendments not later than 270 days after publication of the final SEC rules. The new listing standards in turn must be effective not later than the first anniversary of the publication of the final SEC rules in the Federal Register.
Companies Affected by the New Listing Standards
The SEC proposal would 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 proposal would not apply to companies whose securities are quoted on the OTC Bulletin Board (OTCBB), the Pink Sheets or the Yellow Sheets, or are not quoted at all, nor would it apply to unit investment trusts or issuers of asset-backed securities.
Audit Committee Member Independence
The proposed requirements are intended to enhance audit committee independence by implementing two basic criteria for determining independence under Section 301 of the Sarbanes-Oxley Act.
No Compensatory Fees. First, audit committee members would be barred from accepting, directly or indirectly, any consulting, advisory or other compensatory fees from the company or an affiliate of the company, other than in the member's capacity as a member of the board of directors and any board committee. The SEC release indicated that indirect compensatory payments include payments to spouses, minor children or stepchildren, or children or stepchildren sharing a home with the member, as well as payments to an entity in which an audit committee member is a partner, member or principal and which provides accounting, consulting, legal, investment banking, financial or other advisory services to the company.
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. A director, executive officer, partner, member, principal or designee of an affiliate would be deemed to be an affiliate for this purpose. The SEC has proposed a safe harbor from the proposed definition of "affiliated person" for non-investment companies. Under the proposed safe harbor, a person who is not an executive officer, director or 10% shareholder of the company would be deemed not to control the company and therefore would not be an affiliated person.
Similarly, 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 SEC proposal contains limited exemptions (summarized below), it is important to note that the SEC proposal would eliminate the "exceptional and limited circumstances" exemptions that exist currently under several SRO rules. In addition, the SEC proposal would not permit SROs to grant exemptions or waivers for particular relationships on a case-by-case basis. The SEC proposal contained only the following exemptions:- one audit committee member may be exempt from the independence requirements for 90 days from the effective date of a registration statement under the Securities Act covering an initial public offering or an initial registration statement under Section 12 of the Exchange Act, if the company is not an investment company; and
- an audit committee member that serves on the board of directors of both a listed parent and a direct or indirect consolidated majority-owned subsidiary may be exempt from the "affiliated person" requirement, if the committee member otherwise meets the independence requirements for both the parent and the subsidiary, including receiving compensation only for serving as a member of the board of directors, audit committee or any other board committee of the parent or subsidiary.
In addition, the SEC proposal would permit other limited exemptions from the independence requirements for controlling shareholders (i.e., owners of a majority of the voting securities), 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 proposed 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 (including resolution of disagreements between management and the auditor regarding financial reporting), 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 has 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. Investment companies generally would remain subject to the proposed requirements regarding audit committee responsibility in all other areas, including compensation and oversight of the auditors.
Power to Engage Independent Consultants and Counsel. The SEC proposal would specifically require audit committees to have the authority to engage any outside consultants and advisors, including counsel, if it determines that their services are necessary to carry out the audit committee's duties.
Funding. The SEC proposal would require SROs to require each listed company to provide appropriate funding, as determined by the audit committee, for the engagement of independent auditors and outside consultants, advisors and counsel.
Procedures for Handling Complaints
Under the SEC proposal, 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 would have the flexibility to develop procedures appropriate for their circumstances.
Disclosure Changes
Disclosure Regarding Exemptions. The proposed rules would require that a company relying on one of the exemptions from the independence requirements discussed above would need to 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 proposed rules. The disclosure would need to 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. Foreign private issuers availing themselves of an exemption would be required to file an exhibit to their annual reports stating that they are doing so.
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 has proposed to increase the availability of this basic information by requiring disclosure of the members of the audit committee to 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 proposed listing standards. Instead, the SEC's proposed rules would 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 proposed standards. Accordingly, the proposed rules would require the SROs to establish such procedures before they prohibit the listing of or delist any security of a company for this reason. The SEC has 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 rules of each SRO will provide for definite procedures and time periods for compliance with the proposed requirements to the extent they do not already do so.
Multiple Listings The SEC has also proposed an exemption from the proposed requirements for additional listings of securities by a company at any time the company is subject to the proposed requirements as a result of the listing of a class of common equity or similar securities. The additional listings could be on the same market or on different markets. The SEC also proposed to extend this exemption to listings of non-equity securities by a direct or indirect consolidated majority-owned subsidiary of a parent company, if the parent company is subject to the proposed requirements as a result of the listing of a class of its 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 feel free to contact us either directly or through your regular Goodwin Procter contact if we may be of assistance. An index of all articles on Sarbanes-Oxley prepared by Goodwin Procter is available at: www.goodwinprocter.com/sarbanoxindex.asp
| Stephen W. Carr, P.C. | scarr@goodwinprocter.com | 617.570.1140 |
| James A. Matarese, P.C. | jmatarese@goodwinprocter.com | 617.570.1865 |
| Eric G. Kevorkian | ekevorkian@goodwinprocter.com | 617.570.1057 |
| John O. Newell | jnewell@goodwinprocter.com | 617.570.1475 |
| L. Kevin Sheridan Jr. | lsheridan@goodwinprocter.com | 212.813.8874 |