Sarbanes-Oxley Update: SEC Tightens Standards for Listed Company Audit Committees

Effective April 25, 2003, the Securities and Exchange Commission adopted final rules implementing the audit committee requirements of Section 301 of the Sarbanes-Oxley Act of 2002. See SEC Release No. 34-8220, available at http://www.sec.gov/rules/final/33-8220.htm. Rule 10A-3 under the Securities Exchange Act of 1934:

• sets minimum standards for national securities exchange and NASDAQ listing requirements relating to the independence of directors serving on the audit committee and the audit committee’s responsibilities and oversight role;

• requires national securities exchanges and NASDAQ to have in place revised listing standards incorporating such standards (or more rigorous standards) no later than December 1, 2003. The revisions to the standards for listed company audit committees currently proposed by the NYSE and NASDAQ and published by the SEC for comment meet or exceed the Rule 10A-3 minimums. See SEC Release No. 34-47672 (NYSE) available at http://www.sec.gov/rules/sro/34-47672.htm and SEC Release No. 34-47516 (NASDAQ) available at http://www.sec.gov/rules/sro/34-47516.htm; and

• prohibits the exchanges and NASDAQ from listing any security of an issuer that is not in compliance with the standards once they are in effect.

Listed U.S. companies, other than small business issuers, will be required to comply with the new standards resulting from this rulemaking by their first annual shareholders meeting after January 15, 2004 or by October 31, 2004, whichever occurs first. Listed foreign private issuers and small business issuers will be required to comply by July 31, 2005. Since exchange and NASDAQ proposals (some of which have not yet been published by the SEC for comment) may require earlier compliance and provide additional governance requirements, including stricter standards for director independence generally, issuers should carefully review and monitor applicable listing standards.

The new audit committee standards imposed by Rule 10A-3 apply to SEC reporting companies, including foreign private issuers and small business issuers, whose securities are listed on a U.S. national securities exchange or NASDAQ. The rule does not require that voting equity securities be listed, and covered issuers include those that have listed debt and derivative securities. Other SEC reporting companies who file reports under Section 13(a) or 15(d) of the Securities Exchange Act of 1934 or whose securities are quoted only on an interdealer quotations system (such as the OTC Bulletin Board or the Pink Sheets) are not subject to the rule. However, unlisted companies are required to disclose in their proxy statements whether or not their audit committee members are independent. These issuers may choose any exchange’s or NASDAQ’s definition of independence as approved by the SEC, provided that they disclose which definition was chosen and apply it consistently to all audit committee members.

Rule 10A-3 allows issuers with securities listed in multiple U.S. markets to comply with the minimum listing standards of only one market. A 50%-or-more owned subsidiary with listed non-equity securities (or listed non-convertible, non-participating preferred equity securities) is not required to comply with minimum listing standards under Rule 10A-3, if the subsidiary’s parent is subject to Rule 10A-3 as a result of its own listed stock. Rule 10A-3 also provides certain important exemptions for foreign private issuers (described below), issuers of asset-backed securities, foreign governments and passive trusts.

Section 301 of the Sarbanes-Oxley Act requires that each member of the audit committee of a listed company be independent. Rule 10A-3 implements Section 301 by providing two key criteria of independence:

• No compensation other than director fees. Rule 10A-3 provides that a member of the audit committee is not independent if he or she accepts any consulting, advisory or other compensatory fee from the issuer other than director or committee fees (including equity-based fees for director services). This proscription extends to indirect payments made to spouses and family members, as well as to payments for services to law firms, accounting firms, consulting firms and investment banks for which the director is a partner, member, managing director or executive. There is no de minimis exception. Ordinary course commercial business relationships between an issuer and an entity with which a director has a relationship generally will not affect independence under the rule, although such relationships may affect independence under exchange or NASDAQ standards. In addition, the final rule permits audit committee members to receive fixed amounts under a retirement plan (including deferred compensation) for prior service. While Rule 10A-3 does not "look back" to compensation arrangements existing before appointment to the audit committee, such relationships may preclude independence under pending NYSE and NASDAQ rule proposals.

• Not an "affiliate" of the listed company. Under Rule 10A-3, a member of the audit committee also is not independent if he or she is an "affiliated person" of the listed company or any subsidiary. A person is an "affiliated person" under the rule if he or she, directly or indirectly, controls, is controlled by or is under common control with the issuer under a traditional securities law analysis. The rule provides a "safe harbor" under which a person who is not an executive officer or owner of more than 10% of a class of voting equity securities of the issuer is deemed not to control the issuer. A director that does not meet the safe harbor is not presumed to be an affiliate, however, and a determination of independence will be based on the particular facts and circumstances (although NASDAQ has proposed a "bright line" bar to independence at 20% ownership). The rule specifies that an executive officer, employee-director, general partner or a managing partner of any affiliate of the listed company will also be deemed to be an affiliate of that company. The rule exempts from this criteria an audit committee member who sits on the board of directors of both a listed company

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and its affiliate, if the committee member otherwise meets the independence requirements.

New public companies are not required to have a fully independent audit committee until one year after the effective date of their initial listing or IPO registration statement. However, these companies must have at least one independent member at effectiveness and a majority of independent audit committee members within 90 days of effectiveness.

Under Rule 10A-3, the listing standards of the national securities exchanges and NASDAQ may provide that, if a member of an audit committee ceases to be independent for reasons outside the member’s reasonable control, he or she may remain on the audit committee until the earlier of the issuer’s next annual meeting or one year from the event that caused the member to cease to be independent. The listed company must provide notice to the applicable securities market of such an event and must disclose the reliance on this provision as described below. In addition, Rule 10A-3 requires each exchange and NASDAQ to establish procedures for allowing an issuer to cure a defect before delisting such issuer’s securities.

While the SEC has the authority to grant exemptions from the independence requirements on a case-by-case basis, the SEC has indicated that it does not currently plan to entertain requests for exemptions, waivers or "no-action" letters for particular relationships. Thus, some uncertainty will undoubtedly remain as issuers try to determine whether or not their audit committee members are independent in light of the wide variety of relationships in which a listed company and its directors may be involved.

Oversight of Auditors. Under Rule 10A-3, the audit committee is required to be directly responsible for the appointment, retention (or termination), compensation and oversight of the work of the auditors in connection with the annual audit report. In addition, the auditors must report directly to the audit committee. In the event of a dispute between the auditors and management regarding financial reporting, the audit committee must have the authority definitively to resolve the dispute.

Final Rule 10A-3 includes an instruction clarifying that these requirements do not conflict with, or affect the application of, any requirements under the issuer’s governing law or documents or other home country requirements that shareholders elect, approve or ratify the auditors. However, if the issuer provides a recommendation or nomination of the auditors to the shareholders, the recommendation or nomination must come from the audit committee. The SEC also clarified that Rule 10A-3 does not conflict with any requirements under a listed company’s governing law or documents or other home country requirements that (1) prohibit a board from delegating certain duties to the audit committee or (2) require a governmental entity to select the auditor, although the audit committee must be granted such responsibilities to the extent permitted by law.

Procedures for Handling Complaints. Rule 10A-3 requires that the audit committee of a listed company be responsible for and establish procedures for:

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• 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 concerns regarding questionable accounting or auditing matters.

The SEC expects each issuer to develop procedures that work best for the issuer, and does not mandate any specific procedures.

Authority to Engage Advisors and Funding. Rule 10A-3 mandates that an audit committee must have the authority to engage independent counsel or other advisors as it deems necessary for fulfilling its duties. In addition, each listed company must provide appropriate funding, as determined by the audit committee, to pay the auditors and any advisors employed by the audit committee, as well as to support the audit committee’s ordinary administrative expenses.

To address the difficulty faced by foreign private issuers of complying with inconsistent standards in the United States and their home jurisdictions, the rule provides limited exemptions from certain of the requirements and permits:

• non-management employees to serve on the audit committee under governing law or documents (including collective bargaining agreements) or other home country legal or listing requirements;

• two-tiered boards (i.e., a two-board structure in which one board consists of members of management and the other board consists of non-management persons as mandated by the home country) where the non-management board, or a portion thereof, serves as the audit committee;

• a shareholder, or its representative, to serve on the audit committee, if certain conditions are met;

• representatives of a foreign government to serve on the audit committee, if certain conditions are met; and

• a statutory auditor or a "board of auditors" to perform the audit committee’s auditor oversight role, if specified conditions are met.

Use of Certain Exemptions. Issuers taking advantage of the rule’s exemptions for new public companies, foreign private issuers or audit committee members who cease to be independent for reasons outside of their control will be required to disclose in their annual SEC reports on Form 10-K, 10-KSB, 20-F or 40-F their reliance on the exemption, and their assessment of whether such reliance would "materially adversely affect the ability of the audit committee to act independently and to satisfy the other requirements" of Rule 10A-3. For

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domestic issuers subject to the SEC’s proxy rules, this disclosure would also be required in proxy or information statements relating to the election of directors. In the final rules, the SEC eliminated a previously proposed requirement that foreign private issuers using the exemption for boards of auditors file an additional exhibit.

Identification of Audit Committee Members in Annual Reports. The adopting release requires listed issuers to include or incorporate by reference disclosure identifying the members of their audit committee in annual reports on Form 10-K, 10-KSB, 20-F or 40-F, as currently required in proxy or information statements relating to the election of directors. In addition, because the Exchange Act as amended provides that, in the absence of an audit committee, the entire board of directors will be considered to be the audit committee, the rules require a listed issuer that has not separately designated an audit committee to disclose that the entire board of directors is acting as such.

Audit Committee Financial Expert for Foreign Private Issuers. To clarify an issue left open under the SEC’s final audit committee financial expert rules, the SEC has specifically required listed foreign private issuers to disclose in annual reports on Form 20-F or 40-F the name of the audit committee financial expert and whether that person is "independent" (as defined by the applicable listing standards). Foreign private issuers need not comply with these disclosure requirements until July 31, 2005.

Listed companies should review their audit committee charters and other governing documents now to ensure that their audit committees have the powers and independence required under Rule 10A-3. As the stock exchanges and NASDAQ adopt the requirements mandated by the rule, audit committee policies and procedures also should be revised as appropriate to harmonize them with the applicable requirements. Listed companies should also broaden or revise their annual D&O questionnaires to include questions that will provide the necessary backup for independence determinations under Rule 10A-3 and applicable exchange or NASDAQ listing requirements.

                                                             April 23, 2003