NEW FORMAT Audit Committee
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NEW FORMAT Audit Committee

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January 22, 2003CORPORATE GOVERNANCE ALERTLISTED COMPANY AUDIT COMMITTEE STANDARDS -SEC PROPOSES RULE IMPLEMENTING SECTION 301OF THE SARBANES-OXLEY ACTOn January 8, 2003, the Securities and Exchange Commission(SEC) proposed a new rule, as directed by Section 301 of theSarbanes-Oxley Act of 2002 (the Act), directing the nationalsecurities exchanges and national securities regulatory associa-tions (SROs) to prohibit the initial or continued listing of secu-rities of any issuer that is not in compliance with the auditcommittee requirements established by the Act and the pro-posed rule. The requirements of the proposed rule relate to:• the independence of audit committee members the audit committee’s responsibility to select and oversee the issuer’s inde-pendent accountant procedures for handling complaints regarding the issuer’s accounting prac-tices the authority of the audit committee to engage advisers funding for the independent auditor and any outside advisers engaged by theaudit committee. Under the Act, the proposed rule must become effective by April 26, 2003.However, the new requirements would need to be put in place by the SROs nolater than the first anniversary of the publication of the SEC’s final rule in theFederal Register. The SROs also must impose an obligation on their listed compa-nies that requires the listed companies to provide the SRO with notice promptlyafter an executive officer becomes aware of any material ...

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January 22, 2003
This document is distributed for informational use only; it does not constitute legal advice and should not be used as such.
© 2003 Akin Gump Strauss Hauer & Feld LLP
LISTED COMPANY AUDIT COMMITTEE STANDARDS
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SEC PROPOSES RULE IMPLEMENTING SECTION 301
OF THE SARBANES-OXLEY ACT
On January 8, 2003, the Securities and Exchange Commission
(SEC) proposed a new rule, as directed by Section 301 of the
Sarbanes-Oxley Act of 2002 (the Act), directing the national
securities exchanges and national securities regulatory associa-
tions (SROs) to prohibit the initial or continued listing of secu-
rities of any issuer that is not in compliance with the audit
committee requirements established by the Act and the pro-
posed rule.
The requirements of the proposed rule relate to:
• the independence of audit committee members
• the audit committee’s responsibility to select and oversee the issuer’s inde-
pendent accountant
• procedures for handling complaints regarding the issuer’s accounting prac-
tices
• the authority of the audit committee to engage advisers
• funding for the independent auditor and any outside advisers engaged by the
audit committee.
Under the Act, the proposed rule must become effective by April 26, 2003.
However, the new requirements would need to be put in place by the SROs no
later than the first anniversary of the publication of the SEC’s final rule in the
Federal Register
.
The SROs also must impose an obligation on their listed compa-
nies that requires the listed companies to provide the SRO with notice promptly
after an executive officer becomes aware of any material noncompliance by the
issuer with the requirements of the proposed rule.
The provisions of the new rule
are applicable to all companies
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foreign or domestic
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that have securities (e.g.,
CORPORATE GOVERNANCE ALERT
equity, debt or derivatives) listed on a national securities exchange or an automated inter-dealer quo-
tation system.
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Requirements of the new rule will not, however, be imposed on other reporting compa-
nies registered with the SEC under Section 13(a) or 15(d) of the Exchange Act.
AUDIT COMMITTEE INDEPENDENCE
The new rule (Exchange Act Rule 10A-3) requires each audit committee member to be a member of
the issuer’s board of directors and be “independent.”
The rule states that to be considered “independ-
ent,” a committee member may not, except in his or her capacity as a board or committee member, (i)
accept, directly or indirectly, any consulting, advisory or other compensatory fee from the issuer or (ii)
be an affiliated person of the issuer or any subsidiary thereof.
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Nevertheless, if an audit committee
member also is a shareholder of the issuer, the receipt of any payments made by the issuer to all
shareholders generally (e.g., dividends) would not result in such member being deemed non-independ-
ent.
The SEC clarified that indirect compensatory fees include payments to spouses, minor
children/stepchildren or children/stepchildren sharing a home with a committee member, as well as
payments to an entity in which an audit committee member is a partner, member, principal or the
like, and which entity provides accounting, consulting, legal, investment banking, financial or other
advisory services or similar services to the issuer.
In addition, the SEC stated that it intends to define the terms “affiliate” and “affiliated person” con-
sistent with its other definitions of those terms under the securities laws, such as rule 405 under the
Securities Act, with the caveat that it will recognize a safe harbor for purposes of the new rule.
Under
the new rule, an affiliate of, or a person affiliated with, a specific person will mean “a person that
directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under com-
mon control with, such issuer.”
The term “control” will be defined consistently with other uses of such
term under the securities laws, i.e., “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.”
Under the safe harbor of the proposed rule, a person who is not
an executive officer or director of the issuer, or the beneficial shareholder, directly or indirectly, of
more than 10 percent of the issuer’s equity securities, would be deemed not to control the issuer, and
thus would not be an “affiliate” of the issuer.
Audit committee members who do not fall within the scope of the safe harbor can still rely on a facts
and circumstances analysis if such members believe that they do not control the issuer.
However, for
practical purposes, the parameters established by the proposed safe harbor are likely to lead many
public companies to shy away from appointing to the audit committee shareholders owning more than
10 percent of the issuer’s securities.
This document is distributed for informational use only; it does not constitute legal advice and should not be used as such.
© 2003 Akin Gump Strauss Hauer & Feld LLP
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As proposed, issuers that have securities quoted on Nasdaq will be subject to the new rule, but issuers with securities
quoted on the OTC Bulletin Board, the Pink Sheets and the Yellow Sheets will not be subject to the requirements of the
proposed rule.
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This is the proposed rule for non-investment company issuers.
The SEC's proposed rule sets forth separate and distinct
independence requirements for investment company issuers.
Provisions of the proposed rule applicable to investment
company issuers are not addressed in this alert.
Although the SEC’s proposed rule sets forth specific requirements with respect to audit committee
independence, it is not the only directive that public companies will need to be concerned about.
Some
SROs (including the New York Stock Exchange and Nasdaq) have already proposed separate, and in
some cases more rigorous, listing standards for independent directors and audit committee members
that listed companies will need to understand and comply with, in addition to the SEC’s new rule.
(The SEC has yet to act on many of the proposed listing standards submitted to it by the New York
Stock Exchange and Nasdaq, and noted in the release that such listing standards are currently under
consideration.
For a summary of the proposed listing standards of the New York Stock Exchange and
Nasdaq, see our alerts at www.akingump.com/docs/publication/468.pdf and
www.akingump.com/docs/publication/470.pdf, respectively.)
Therefore, compliance with the proposed
rule is required, but
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depending upon the listing standards adopted by the marketplace on which the
issuer’s securities are traded
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may not be totally sufficient.
For foreign private issuers required by home country law to have a two-tier board, i.e., a management
board and a supervisory or non-management board, the requirements of the proposed rule will apply
to the issuers’ supervisory or non-management board.
The supervisory board may elect to establish a
separate audit committee of its members, or the entire supervisory board could function as the issuer’s
audit committee, provided that all members of such supervisory board meet the independence require-
ments of the proposed rule.
RESPONSIBILITIES WITH RESPECT TO OUTSIDE AUDITORS
One of the objectives of the new rule is to enhance the independence of the audit function, thereby fur-
thering the objectivity of financial reporting.
The SEC believes that the audit process is subject to
compromise when the outside auditors perceive that they are beholden to management rather than to
serve under the direction and at the pleasure of the issuer’s board or audit committee.
The new rule
mandates that audit committees have responsibility and authority for the appointment, compensation,
retention and oversight of the outside auditor.
The committee’s oversight responsibilities would
include having the authority to approve all audit engagement fees and terms, along with all significant
non-audit engagements.
In addition, the outside auditor must report directly to the audit committee.
The SEC indicated that the requirement of having the audit committee retain the outside auditor
should not conflict with, and would not be affected by, any governing law, contract or home country
requirement that requires shareholders to ultimately elect, approve or ratify the selection of the
issuer’s outside auditor.
The SEC did note, however, that if generally the board recommended or nom-
inated the outside auditor to the issuer’s shareholders, it should delegate the responsibility for making
such recommendation or nomination to the audit committee.
Even in situations where the board of a
foreign private issuer is restricted by law from delegating this responsibility, the SEC contemplates
that a board could provide the audit committee with advisory powers (including the power to submit
nominations to the board) with respect to selection of the outside auditor.
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This document is distributed for informational use only; it does not constitute legal advice and should not be used as such.
© 2003 Akin Gump Strauss Hauer & Feld LLP
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PROCEDURES FOR HANDLING COMPLAINTS
In order to fulfill its responsibilities of enhancing the audit function, an audit committee must be pro-
vided with all material information regarding the issuer’s financial reporting.
By giving the audit
committee hiring and firing authority over the outside auditor and by requiring outside auditors to
report directly to the audit committee, the SEC has sought to remove any hurdles or disincentives
that the outside auditor may have about raising concerns with respect to an audit of the issuer.
In
addition, any impediments to the internal auditors voicing their concerns must also be addressed.
Under the proposed rule, SROs must require that audit committees establish procedures for:
• the receipt, retention and treatment of complaints received by the issuer regarding accounting,
internal accounting controls or auditing matters
• the confidential, anonymous submission by employees of the issuer of concerns regarding ques-
tionable accounting or auditing matters.
By requiring listed companies to establish formal procedures for handling such complaints, the SEC is
hopeful that audit committees will be alerted about potential problems before serious consequences
arise.
The SEC is not mandating specific procedures for audit committees to adopt.
Rather, it expects
each audit committee to develop procedures that work best for the issuer’s individual circumstances.
ADVISERS AND FUNDING
Under the proposed rule, each audit committee would need to be granted authority to engage its own
advisers, including accounting, legal and other advisers, as it deems necessary to carry out its duties.
In addition, each audit committee must have appropriate funding, as determined by the audit commit-
tee, for the payment of compensation to (i) any independent accounting firm performing any audit,
review or attest service for the issuer and (ii)
any advisers employed by the audit committee.
EXEMPTIONS
The SEC has used its authority under the Act to exempt from the independence requirements of the
new rule particular relationships, many of which are summarized below.
However, an issuer availing
itself of any specific exemption must disclose its reliance on the exemption and provide an assessment
of whether such reliance would materially adversely affect the ability of the audit committee to act
independently.
This disclosure must be included in the issuer’s annual report and in any proxy state-
ment or information statement provided to its shareholders.
Other than the limited exemptive
authority granted to the SEC, the Act does not contain any exemptive provision for exceptional and
limited circumstances (a provision that currently exists under several SRO rules).
Therefore, the
SEC’s new rule does not allow for any additional exemptions with respect to audit committees.
In
addition, the SEC has stated that it has no plans to entertain exemptions or waivers (or requests for
no-action letters) for particular relationships on a case-by-case basis.
Therefore, a listed company that
cannot comply with the requirements of the proposed rule and that does not fall within the scope of
one of the enumerated exemptions will be subject to delisting by the marketplace on which its securi-
ties are traded.
This document is distributed for informational use only; it does not constitute legal advice and should not be used as such.
© 2003 Akin Gump Strauss Hauer & Feld LLP
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Foreign Issuers
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The SEC has proposed a handful of exemptions exclusively available to foreign pri-
vate issuers that have home country laws in conflict with or other corporate governance arrangements
that differ significantly from general practices among U.S. companies.
As proposed, the SROs would
have no ability to provide foreign private issuers that cannot avail themselves of an enumerated
exemption with an exemption from, or waiver of, the proposed requirements.
The exemptions avail-
able for foreign private issuers are briefly summarized as follows:
• Foreign private issuers incorporated in countries that require companies to have a
non-manage-
ment employee
sit on such companies’ audit committees will be permitted to retain such non-
management employees on their audit committees.
• Foreign private issuers with
controlling shareholders or shareholder groups
(i.e., those own-
ing more than 50 percent of the issuer’s voting securities) will be permitted to have audit commit-
tees in which one member is the controlling shareholder, or representative of a controlling share-
holder group, provided, however, that the member (i) cannot be an executive officer of the issuer,
(ii) can only have observer status on the committee with no voting rights, (iii) cannot chair the
audit committee and (iv) must meet the “no compensation” prong of the independence require-
ment.
• Foreign private issuers that are required to have a
governmental representative
on their audit
committees may have one audit committee member who is a representative or designee of the for-
eign government on the committee, provided that the representative or designee is not an execu-
tive officer of the issuer and meets the “no compensation” prong of the independence requirement.
• Foreign private issuers that have home country laws requiring such issuers to have a
board of
auditors or statutory auditor
(or similar body) separate from the issuer’s board of directors will
be exempt from the independence requirements of the proposed rule.
The issuers’ board of audi-
tors will, however, be required to fulfill the other requirements of the proposed rule, including
establishing procedures for handling complaints, having access to advisers and having adequate
funding to fulfill their duties.
The board of auditors would also, to the extent permitted by law,
need to have responsibility for the appointment and retention of the issuer’s outside auditors.
To
rely on this exemption, the issuer must have securities listed on an exchange outside of the United
States, the members of the board of auditors cannot be elected by management and no executive
officer can be a member of such body.
In addition, the issuer’s home country law must set forth
standards for such body to be independent from management and must provide for such body to
have oversight over the work of the issuer’s outside auditor.
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IPO Issuers
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Issuers undertaking an initial public offering (IPO) would be permitted to have one
committee member exempt from the independence requirements for a period of 90 days from the date
the issuer’s registration statement is declared effective.
Parent/Subsidiary Ties
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An audit committee member serving on the board of directors of both a list-
ed company and its direct or indirect consolidated majority-owned subsidiary (or who sits on the
boards of a listed subsidiary and its parent) would be exempt from the “affiliated person” requirement,
assuming that such person otherwise meets the independence requirements for both the parent and its
subsidiary.
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This document is distributed for informational use only; it does not constitute legal advice and should not be used as such.
© 2003 Akin Gump Strauss Hauer & Feld LLP
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This document is distributed for informational use only; it does not constitute legal advice and should not be used as such.
© 2003 Akin Gump Strauss Hauer & Feld LLP
Our lawyers are monitoring these corporate reforms and will keep you apprised of any developments
that arise from the requirements imposed under the Act and from regulatory activity of the SEC.
For
a summary of other key provisions of the Act, as well as Corporate Governance Alerts that provide
detailed analyses of certain other key provisions of the new law, please visit out Web site at
http://www.akingump.com/publication.cfm.
CONTACTINFORMATION
If you have any questions or would like to learn more about this topic, please contact the partner who normally rep-
resents you, or:
Dawn M. Gertz
Director of Client Services
dgertz@akingump.com
1.866.AKINLAW
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