SEC Issues Final Rules On Listed Company Audit Committee Standards

On April 1, 2003, the SEC adopted final rules to satisfy the requirements of Section 301 of the Sarbanes-Oxley Act of 2002. Section 301 of Sarbanes required the SEC to direct the national securities exchanges and associations (such as the NYSE, AMEX and NASDAQ) to prohibit the listing of securities of a company that does not have an audit committee that meets certain standards.

Effective Dates

The final SEC rules require national securities exchanges and associations to submit to the SEC proposed rule amendments to implement the new audit committee standards by July 15, 2003 and to adopt final rules by December 1, 2003. The SEC also noted that the standards set forth in the final rules were minimum standards and the SEC expected that the national securities exchanges and associations would consider the adoption of more rigorous standards. Listed companies must be in compliance with the new standards by the earlier of:

• their first annual shareholders meeting after January 15, 2004, or
• October 31, 2004.

The new disclosure requirements apply to reports covering periods ending on or after the applicable compliance date and to proxy statements for shareholder actions occurring on or after the applicable compliance date.

Foreign private issuers and small business issuers have until July 31, 2005 to comply.

Audit Committee Standards

Independent Audit Committee Members

The final rules require that all members of the audit committee be independent, which requires that the audit committee member:

• not accept directly or indirectly any consulting, advisory or other compensatory fee from the company or its subsidiaries, other than for board and committee service, and
• not be an "affiliated person" of the company or any of its subsidiaries.

Newly public companies are only required to have one independent member of the audit committee at the time of the initial public offering, a majority of independent members within 90 days after the IPO and a committee of only independent directors within one year after the IPO.

Compensatory Fees. In order to be independent, audit committee members are barred from receiving any non-permitted compensation from the company, directly or indirectly. Accordingly, payments to an audit committee member's spouse, minor children or stepchildren or children or stepchildren sharing a home with the member are also prohibited. Similarly, payments to any law firm, accounting firm, consulting firm, investment bank or financial advisory firm in which the member is a partner, member, managing director or executive officer or holds a similar position are prohibited. Payments resulting from commercial relationships other than those specified in the preceding sentence are not prohibited, but the final securities exchange and association rules may extend to other relationships. The prohibition does not apply if the audit committee member is a limited partner, non-managing member or holds a similar position so long as, in each case, the member does not have an active role in providing services to the company. There is no "look back" period; the rule only prohibits payments to members at the time the rules become effective or the person becomes an audit committee member. The stock exchange rules, however, will likely contain a prohibition against receipt of payments in the period that is one or more years prior to the time of the independence determination. There is no de minimis exception for immaterial payments.

The rules note that there is no limit on the amount of compensation that may be paid to audit committee members in their capacity as board or committee members. Also, the rule permits an audit committee member to continue receiving fixed amounts of compensation under a retirement plan, including deferred compensation, so long as the payments are not contingent on continued service.

Affiliated Person. The definition of "affiliated person" is consistent with the typical definition of "affiliate" under the securities laws. Under this definition, an affiliate of a company is "a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with," the company. "Control" is defined 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." Solely for purposes of the definition of "affiliated person" in this context, the SEC created a safe harbor for the determination of whether someone is deemed to "control" the company. The safe harbor provides that a person who is not an executive officer or holder of more than 10% of a class of voting securities of the company will be deemed not to have "control" of the company. The existence of the safe harbor does not mean that a person who owns more than 10% will be deemed to control the company; it only means that other facts and circumstances must be considered to determine whether the person has control. A person who is an executive officer, employee-director, general partner or managing member of an affiliate of the company also will be deemed an affiliate. The SEC also commented that an affiliate could not evade the prohibition by designating a third party representative to act in its place.

Direct Responsibility for the Independent Auditor

The final rules require that the company's audit committee be directly responsible for the appointment, compensation, retention and oversight of the work of the company's independent audit firm. As part of this direct oversight responsibility, the audit committee must:

• be the entity to whom the audit firm directly reports,
• have ultimate authority to approve the terms of all audit engagements and related fees, and be responsible for resolving disagreements between management and the auditors on financial reporting matters.

The final rules permit shareholders to approve or ratify the appointment of the company's independent audit firm if required or permitted under the company's governing documents or the laws of the governing jurisdiction. However, any recommendation or nomination from the company regarding the appointment or ratification of the independent audit firm must come from the audit committee.

Procedures for Whistleblower Complaints

The final rules require audit committees 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, anonymous submission by the company's employees regarding questionable accounting or auditing matters.

The final rules do not mandate specific procedures to satisfy this requirement and acknowledged that companies should have the flexibility to develop and utilize procedures appropriate for the company's particular circumstances. See our article on Whistleblower Protections and Audit Committee Complaint Procedures under Sarbanes-Oxley for more information on whistleblower procedures.

Authority to Engage Independent Advisers

The final rules require that the audit committee have the authority to engage independent counsel and other advisers as it determines necessary to carry out its duties. The SEC specifically noted that this provision does not impose a requirement for audit committees to hire independent advisers and it does not prohibit the audit committee from seeking advice from the company's internal or regular outside counsel.

Availability of Funding

The final rules require that the company provide the audit committee with appropriate funding, as determined by the audit committee, for the audit committee to:

• compensate the company's independent audit firm for the services related to the preparation and issuance of the audit report and other audit, review and attest services,
• compensate any independent advisers retained by the audit committee, and
• pay for ordinary administrative expenses that the audit committee determines necessary to carry out its duties.

Disclosures Regarding Audit Committees

The final rules require the following new or revised disclosures:

• Disclosure of the company's reliance on any exemption from compliance under the rules and the company's assessment of how much, if at all, such reliance will materially adversely affect the ability of the company's audit committee to act independently and satisfy the other requirements of the rules. This disclosure must appear in, or be incorporated by reference into, annual reports on Form 10-K and must appear in proxy statements for shareholders meetings at which directors will be elected.
• Disclosure of the identity of the members of the company's audit committee (or, if in the absence of an audit committee, the entire board of directors is serving as the audit committee, the identity of all board members) must appear in the company's annual report on Form 10-K. Because this information, as well as information about the functions of the audit committee and the number of meetings held by the audit committee in the prior year, is already required in the company's proxy statement, this information can be incorporated by reference from the proxy statement.
• Disclosure of whether the members of the company's audit committee are independent as defined by the applicable national securities exchange listing standards, including any amendments effected to implement the new independence standards required by these rules. Issuers that are listed on the NYSE, AMEX or NASDAQ are already required to disclose whether their audit committee members are independent as defined under such listing standards. This disclosure will continue to be provided in any proxy statement that requires action on the election of directors. Non-listed companies may still choose any one of the national securities exchange or association definitions of independence for purposes of making the required disclosure.

Failure to Comply and Opportunity to Cure

If a company fails to comply with these standards, the final rules require that the applicable national securities exchange or association give the company an opportunity to cure the defect before the company's securities are delisted. The SEC indicated that existing delisting procedures generally provide sufficient procedures and opportunity for companies to cure any defects.

RECOMMENDED COMPLIANCE ACTIONS

Certain actions companies should consider to transition toward compliance with these new rules are listed below. As a reminder, the stock exchange rules implementing these standards may contain additional, more rigorous requirements.

Considerations for Audit Committee Charters

Consider adding the following provisions to the company's Audit Committee Charter:

• All members of the Committee shall be independent as defined by Section 10A-3(b)(1) of the Exchange Act.
• The Committee is directly responsible for the appointment, compensation, retention and oversight of the work of the Company's independent auditor engaged for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the Company.
• The Company's independent auditor shall report directly to the Committee.
• The Committee is responsible for resolving any disagreements between the Company's management and independent auditor regarding financial reporting.
• The Committee shall establish procedures for (a) the receipt, retention, and treatment of complaints received by the Company regarding accounting, internal accounting controls and auditing matters and (b) the confidential, anonymous submission by employees of the Company of concerns regarding questionable accounting or auditing matters.
• The Committee may engage independent counsel and other advisers as it determines necessary to carry out its duties.
• The Committee may use funds from the Company to (a) compensate any independent auditor engaged by the Committee for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the Company, (b) compensate any advisers employed by the Committee, and (c) pay for any ordinary administrative expenses of the Committee that are necessary to carry out its duties.

Considerations for Audit Committee Meeting Agendas

Action items to be completed prior to the effective date of the new rules:

• Amend audit committee charter
• Approve whistleblower policy and procedures

Annual action items:

• Confirm independence of committee members and submit information to full board to enable board to make independence determinations
• Approve engagement of audit firm to provide audit, review and attest services
• Evaluate audit firm and confirm decision to retain audit firm, or undertake to terminate the current audit firm and hire a new audit firm
• Evaluate effectiveness of whistleblower policies and procedures

Quarterly action items:

• Meet with independent auditors to discuss audit and financial reporting matters (meet in executive session as often as audit committee determines appropriate)
• Review whistleblower complaints involving accounting and auditing matters, or obtain report from member of committee responsible for handling such complaints

As necessary:

• Resolve disagreements between the independent auditors and management involving financial reporting matters
• Discuss whistleblower complaints requiring full committee attention
• Engage independent advisers
• Request funding from company for payment to audit firm and any independent advisers hired by audit committee

Considerations for Periodic Report Disclosures

• Disclose in Form 10-K and any proxy statement relating to the election of directors any compliance exemptions upon which the company is relying (disclosure in Form 10-K can be incorporated by reference from the proxy statement)
• Disclose in the Form 10-K, or incorporate by reference from the proxy statement, the identity of the audit committee members
• Update disclosure in proxy statements as to independence of audit committee members to apply the listing standard, as revised or implemented pursuant to the new rules, of the applicable national securities exchange or association (unlisted companies can still choose the definition from any national securities exchange or association)

Other Considerations

Add the following questions to the company's D&O questionnaire for audit committee members:

• Since [beginning of fiscal year], have you accepted directly or indirectly any consulting, advisory or other compensatory fee from the Company or any of its subsidiaries, other than fees for services rendered as a member of the Audit Committee, the board of directors or any other board committee?

No _________ Yes ________

• Are you an "affiliated person" of the Company or any of its subsidiaries, other than as a director of the Company? (Note: If you are not an executive officer or holder of more than 10% of any class of the Company's voting securities, you should check "no.")

No _________ Yes ________