Assignment 2 ACG6657
Audit Committee Director Independence Rule (Release No. 33-8220. SEC 2003)
Audit Committee (AC) Member Independence
… An audit committee (AC) comprised of independent directors is better situated to assess objectively the quality of the issuer's financial disclosure and the adequacy of internal controls than a committee that is affiliated with management.
Management may face market pressures for short-term performance and corresponding pressures to satisfy market expectations.
These pressures could be exacerbated by the use of compensation or other incentives focused on short-term stock appreciation, which can promote self-interest rather than the promotion of long-term shareholder interest.
An independent AC with adequate resources helps to overcome this problem and to align corporate interests with those of shareholders.
These requirements standing alone do not, for example, preclude independence on the basis of other commercial relationships not specified in the final rule, and they do not extend to the broad categories of family members that may be reached by SRO listing standards.
Instead, as proposed, our requirements build and rely on SRO standards of independence that cover additional relationships not specified in Exchange Act Section 10A(m).
Our final rule allows SROs flexibility to adopt and administer additional requirements of these sorts through SRO rulemaking …
We will review the rules submitted by the SROs to implement Exchange Act Rule 10A-3 so that they contain appropriate overall standards for audit committee independence
Advising, Consulting or Compensatory Fees
As for the two criteria for independence in Exchange Act Rule 10A-3, the first is that audit committee members are barred from accepting any consulting, advisory or other compensatory fee from the issuer or any subsidiary thereof, other than in the member's capacity 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, as well as other compensatory payments.
Indirect compensation
To prevent evasion of the requirement, disallowed payments to an audit committee member includes payments made either directly or indirectly. …
The final rules, therefore, mandate that indirect acceptance of compensatory payments includes payments to spouses, minor children or stepchildren or children or stepchildren sharing a home with the member. In addition, indirect acceptance includes payments accepted by an entity in which such member is a partner, member, officer such as a managing director occupying a comparable position or executive officer, or occupies a similar position … and which provides accounting, consulting, legal, investment banking or financial advisory services to the issuer or any subsidiary.
… … the prohibitions … do not include non-advisory financial services such as lending, check clearing, maintaining customer accounts, stock brokerage services or custodial and cash management services.
Only for AC directors
… the final rule relates only to requirements for audit committee membership.
They do not affect the ability of a director associated with an entity that provides such services to a listed issuer from otherwise serving on that issuer's board of directors, again to the extent other SRO rules permit such relationships. …
The final rule specifies 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 listed issuer (provided that such compensation is not contingent in any way on continued service)
New public company exception
… Before completion of a company's initial public offering, the board of directors often will consist primarily, if not exclusively, of representatives of venture capital investors and insiders. …
to balance the concerns between the need for independence and the ability to recruit qualified candidates, we are adopting a revised exception … that requires at least one fully independent member at the time of an issuer's initial listing, a majority of independent members within 90 days, and a fully independent committee within one year. …
AC Responsibilities towards the Auditor
… The auditing process may be compromised when a company's outside auditors view their main responsibility as serving the company's management rather than its full board of directors or its audit committee.
This may occur if the auditor views management as its employer with hiring, firing and compensatory powers. Under these conditions, the auditor may not have the appropriate incentive to raise concerns and conduct an objective review.
Further, if the auditor does not appear independent to the public, then investor confidence is undermined and one purpose of the audit is frustrated.
One way to help promote auditor independence, then, is for the auditor to be hired, evaluated and, if necessary, terminated by the audit committee. This would help to align the auditor's interests with those of shareholders.
… we are adopting as proposed the requirement that the audit committee … will need to be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm 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 issuer, and the independent auditor will have to report directly to the audit committee.
These oversight responsibilities include the authority to retain the outside auditor, which includes the power not to retain (or to terminate) the outside auditor. In addition, in connection with these oversight responsibilities, the audit committee must have ultimate authority to approve all audit engagement fees and terms.
AC oversight of Internal Audit
… we requested comment on whether other responsibilities… should be under the supervision of the audit committee, such as the appointment, compensation, retention and oversight of an issuer's internal auditor. Commenters were split … with the majority not supporting action by the Commission at this time. Given this split, we are not extending the responsibility requirement to include such oversight.
Non-US jurisdictions
… none of the audit committee requirements in the final rule conflicts with, nor do they affect the application of, any requirement or ability under an issuer's governing law or documents or other home country legal or listing provisions that requires or permits shareholders to ultimately vote on, approve or ratify such requirements.
… in some jurisdictions, the outside auditor can only be removed by court order upon specified circumstances. Other commenters noted that the government is required to select the outside auditor for some foreign private issuers. …
we are providing an additional instruction to clarify that the requirements in the final rule do not conflict with any legal or listing requirement in an issuer's home jurisdiction vesting such responsibilities with a government entity or tribunal.
AC role in receiving complaints
Since the audit committee is dependent to a degree on the information provided to it by management and internal and outside auditors, it is imperative for the committee to cultivate open and effective channels of information.
Management may not have the appropriate incentives to self-report all questionable practices. A company employee or other individual may be reticent to report concerns regarding questionable accounting or other matters for fear of management reprisal.
The establishment of formal procedures for receiving and handling complaints should serve to facilitate disclosures, encourage proper individual conduct and alert the audit committee to potential problems before they have serious consequences.
Whistleblowing
Accordingly, under the listing standards called for by our final rules, each audit committee must establish procedures for:
The receipt, retention and treatment of complaints received by the issuer regarding accounting, internal accounting controls or auditing matters, and
The confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters.
… we are not mandating specific procedures that the audit committee must establish. …
Similarly, we are not adopting the suggestion that … the requirement should be limited to only employees in the financial reporting area.
Audit committee use of outside experts
To be effective, an audit committee must have the necessary resources and authority to fulfill its function. …
To perform its role effectively, therefore, an audit committee may need the authority to engage its own outside advisors, including experts in particular areas of accounting, as it determines necessary apart from counsel or advisors hired by management, especially when potential conflicts of interest with management may be apparent.
The advice of outside advisors may be necessary to identify potential conflicts of interest and assess the company's disclosure and other compliance obligations with an independent and critical eye. … The assistance of outside advisors also may be needed to independently investigate questions that may arise regarding financial reporting and compliance with the securities laws.
… the final rule specifically requires an issuer's audit committee to have the authority to engage outside advisors, including counsel, as it determines necessary to carry out its duties.
Funding for outside experts
… the final rule requires the issuer to provide for appropriate funding, as determined by the audit committee, in its capacity as a committee of the board of directors, for payment of compensation:
To any registered public accounting firm engaged for the purpose of preparing or issuing an audit report or performing other audit, review or attest services …; and
To any advisors employed by the audit committee.
Not only could an audit committee be hindered in its ability to perform its duties objectively by not having control over the ability to compensate these advisors, but the role of the advisors also could be compromised if they are required to rely on management for compensation. Thus, absent such a provision, both the audit committee and the advisors could be less willing to address disagreements or other issues with management.
Audit Committee expenses
Some commenters believed it would be appropriate to supplement the funding requirements. … Specifically, these commenters believed the final rule should also state that the issuer must provide appropriate funding for ordinary administrative expenses of the audit committee. We find merit in this suggestion.
An audit committee's effectiveness may be compromised if it is dependent on management's discretion to pay for the committee's expenses, especially when potential conflicts of interest with management may be apparent.
Accordingly, the final rule provides that, in addition to funding for advisors, the issuer must provide appropriate funding for ordinary administrative expenses of the audit committee that are necessary or appropriate in carrying out its duties.