New Requirements for Audit Committees

April 24, 2002

My remarks today address what some have called “reforms” to the audit committees of public companies. Although rigorous and important, the new rules of the Securities Exchange Commission (SEC), New York Stock Exchange (NYSE)and National Association of Securities Dealers (NASD) could be described more accurately as “enhancements,” in that no fundamental change has been made in the audit committees’ responsibilities.

Historically, the SEC has been rather quiet on issues concerning corporate governance. In 1998, this began to change as the SEC Chairman started to speak out forcefully on the duties of directors generally and audit committees specifically. Why audit committees suddenly gained a prominent position on the Chairman’s agenda can be explained by a number of developments.

Two high-profile cases in 199697 underscored the director’s duty of oversight. One case, Caremark, arose after that company incurred massive liabilities for its illegal business practices under Medicare laws. Shareholders asked, “Where were the directors?”—and sued them for failure to provide adequate oversight. The other case, W.R. Grace, involved related party transactions with the CEO and his son. At least two directors were fully aware but failed to ensure that the transactions were reported properly.

At about this time, the so-called COSO Study was published. The Study examined a sampling of 200 cases alleging accounting fraud in the preceding 11 years. The findings of the Study demonstrated a need for strengthening board oversight and energizing audit committees. In 83 percent of the cases, the CEO or CFO was allegedly associated with the wrongful conduct. In 25 percent, the target companies had no audit committee; of the remaining 75 percent, more than half met only once per year, two-thirds had no member with expertise in finance or accounting and almost two-thirds had one or more insiders as members.

These legal developments occurred in an atmosphere—which continues today—in which public companies are under enormous pressure from Wall Street to meet earnings expectations. Failure to report results measuring up to analyst expectations often brings severe punishment by the investment community. That has given impetus, in the view of the SEC Chairman and others, to the phenomenon of creative accounting and “earnings management.”

In the Chairman’s speeches and articles during 1998, intensified focus was cast upon audit committees because of their special oversight role in financial reporting. He pointed out that, although outside auditors are supposed to be “watchdogs,” they need board-level help in fulfilling that role. The point was also made that the watchdogs need to be watched, so that the investing public can be assured of auditor independence. The Chairman further used his pulpit to tell audit committees how they should go about their business—they should intervene in earnings management and concern themselves about the quality of their companies’ accounting practices.

As mentioned, it had not previously been SEC policy to intrude in matters of corporate governance. That, in no small way, is due to the fact that its jurisdiction is limited by statute. Nevertheless, the Chairman succeeded in converting his importuning into a set of national rules and standards, which he accomplished by approaching the NYSE and NASD and inviting them (or telling them) to upgrade the requirements for audit committees of listed companies.

They quickly obliged. By February 1999, a “blue ribbon committee” issued recommendations for improving the effectiveness of audit committees. Seven months later, the NYSE and NASD issued proposals, based on these recommendations, to amend their listing requirements. On December 14, 1999, the SEC approved the proposals and amended its proxy rules to require more disclosures on audit committee composition and operation. A brief summary of the new requirements follows.

Audit committees must be comprised of at least three directors. All must be “independent” and financially literate. One member must have expertise in finance or accounting. The committee must have a written charter that is reviewed annually and published every three years in the proxy statement. The committee must also provide a report in the annual proxy statement, and disclose (among other things) whether it “recommended” to the board that the audited financial statements be included in the company’s annual report.

There are troubling aspects to these new rules. One is that the NYSE and NASD standards for “independence,” although similar, are not uniform and can produce different results in determining eligibility for membership on the audit committee. It does not make sense to have federal-level rules that allow (and may even force) inconsistency.

Another troubling factor is that the new standards for independence which apply to the audit committee bear no resemblance to those which apply to the outside auditor. As to the latter, the core requirement is that the auditor must have no financial interest in the audit client—a notion completely absent from the NYSE and NASD criteria. Their rules are dominated by concerns about business relationships, and essentially presume that individual directors who have a business relationship with the company (e.g., bankers, suppliers, customers, legal advisors, etc.) are compromised in bringing sufficient integrity to the oversight process. This, too, makes little sense. It would be more reasonable to presume that such individuals are likely to have a special interest in assuring that the company’s financial results are fairly reported.

In order to give meaning and content to the new rules, the bureaucracies at the SEC, NYSE and NASD are likely to take us down the path of more regulations and more work for lawyers and accountants in coping with them. The necessary enhancements could have been achieved, at lesser social cost, by developing a set of “best practices” and a flexible framework within which the boards of public companies could experiment on a voluntary basis.

For more information, please contact ccohen@cohenlaw.com.