Listed Company Audit Committee Standards

The audit committee of the board of directors of a public company plays a critical role in providing oversight of the company’s financial reporting system. A properly functioning audit committee not only provides independent review, but also a non-management forum in which auditors and employees can voice concerns about a company’s financial reporting process.

The SEC has recently adopted new rules prohibiting U.S. securities exchanges and national securities associations from listing any security of a company that is not in compliance with the audit committee requirements of the Sarbanes-Oxley Act. These new rules will apply to listed companies of all sizes. "Listed" companies are those whose securities are listed for trading on a national securities exchange or in an automated inter-dealer quotation system of a national securities association.

Most listed companies must comply with the new listing rules by the earlier of the first annual shareholders meeting after January 15, 2004 or October 31, 2004. Foreign private issuers and small business issuers must comply with new listing rules by July 31, 2005.

The new SEC regulations set forth the following rules for audit committees:

• each member must be an independent director
• to be independent for audit committee service, a director may not:
• perform any non-board consulting, advisory or other services for compensation (unless the stock exchange rules provide otherwise, a director can receive retirement plan payments for prior service to the company), or

- be an affiliate of the company or its subsidiaries

There are exceptions to the independence requirements. These include:

• for newly listed companies following an IPO,

- for the first 90 days, only one of the members of the audit committee need be independent, and

- for the first year, only a majority of members of the audit committee need be independent

• audit committee members can be on the boards of subsidiary companies
• non-executive employees of a foreign private issuer may be exempt under certain circumstances, depending on whether membership on the board is required by law, under a collective bargaining agreement or home country listing requirement, or if the member is a foreign government or affiliate appointment
• the SEC has the authority to grant additional exemptions

The audit committee of each listed company will be directly responsible for the appointment, retention and oversight of the company’s auditors. The audit committee will also be responsible for resolving all disagreements between management and the auditors regarding financial reporting. The audit firm must report directly to the audit committee.

Practically, what this means is as follows:

• the engagement letter between the auditors and the company must be negotiated and executed by the audit committee
• the audit committee must negotiate audit fees
• companies may want to reconsider shareholder ratification of the auditors at annual meetings, given that retention of the auditors is the responsibility of the audit committee
• audit committee charters must be amended to reflect these responsibilities

Each audit committee must now establish procedures for receiving complaints on accounting matters, including procedures for the confidential, anonymous submission by employees of questionable accounting or audit practices. Because the auditors and the audit committee are, to a certain extent, dependent upon the reporting of information by employees and management, the integrity of the financial reporting system necessitates a procedure for anonymous reporting of questionable practices. Without confidential "whistleblowing" policies, no employee or member of management would have the incentive or requisite protection to disclose improper practices.

The SEC has not mandated specific guidelines for implementing complaint procedures. The audit committee will have the flexibility to determine the appropriate system in light of the company’s size, circumstances and personnel. Alternatives being explored and implemented range from submission of anonymous written complaints to an audit committee mailbox to hot lines staffed by outside providers.

An audit committee must have the authority to engage independent legal counsel and other advisers, and the company must provide the funding. The company is also obligated to provide the funding for the audit committee to engage the independent auditors.

The SEC has amended its disclosure regulations to require that a public company include in its annual reports and proxy statements:

• whether the company has a separately designated audit committee
• if there is such a committee, the identity of the members
• whether the entire board of directors acts as the audit committee
• whether the company is relying on a specified exemption from the independence requirement for members of the audit committee

A non-listed public company (e.g., whose securities are traded over the counter on the electronic bulletin board) that has a separately designated audit committee will be required to disclose whether the members of its audit committee are independent. These companies must comply with the independence requirements of Sarbanes-Oxley and may then choose any exchange definition of independence approved by the SEC. The definition chosen must be applied uniformly to all members of the audit committee.

It should be noted that the U.S. exchanges have already indicated additional standards for the determination of the independence of members of the audit committee. Listed companies must comply with both the SEC regulations on independence and the applicable exchange regulations when approved by the SEC in final form later this year. Based on the proposals currently available, the New York Stock Exchange and NASDAQ have set standards of independence that are not uniform, and therefore, the standards may be slightly different depending upon the exchange or system on which the issuer’s securities are traded.

As noted above, a director cannot simultaneously be an affiliate of a listed company and be independent. An "affiliate" is generally understood to be a person in a control relationship with another person. For example, directors and executive management and the parent or subsidiaries of a company are affiliates of that company. The SEC has created a safe harbor so that a person is not deemed to be an affiliate of a listed company if the person is not the beneficial owner, directly or indirectly, of more than 10% of any class of voting equity securities of the company and if the person is not an executive officer of the company. The SEC was very clear in saying that the safe harbor is that only; it does not create a presumption that more than 10% stock ownership is determinative of affiliate status.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.