Sullivan & Cromwell LLP
125 Broad Street
New York, New York 10004-2498
212 558-4000
February 18, 2003
VIA E-MAIL: rule-comments@sec.gov
Mr. Jonathan G. Katz,
Secretary,
Securities and Exchange Commission,
450 Fifth Street, N.W.,
Washington, D.C. 20549-0609.
Re: Proposed Rule Regarding Standards Relating to Listed Company Audit Committees (File No. S7-02-03)
Dear Mr. Katz:
We are pleased to respond to Release Nos. 33-8173, 34-47137, IC-25885 (the "Proposing Release") in which the Securities and Exchange Commission (the "Commission") solicited comments on a proposed rule implementing Section 301 of the Sarbanes-Oxley Act of 2002 ("SOA") relating to public company audit committees.
We believe that the proposed rule is broadly consistent with the policies underlying Section 301 of SOA and appropriately seeks to accommodate the corporate governance arrangements of non-U.S. issuers. We have, however, some suggestions on how the proposed rules may be modified in order to further promote the purposes of Section 301 of SOA and more effectively accommodate non-U.S. issuers.
Since this letter addresses certain issues concerning non-U.S. issuers with a board of auditors (or similar bodies) or statutory auditors, we are also responding to Release Nos. 33-8177, 34-47235, in which the Commission requested comments regarding the treatment of such issuers for purposes of the "audit committee financial expert" disclosure requirement.
I. General
1. The rule should contain a provision, similar to the safe harbor provision in the final "audit committee financial expert" rule, to the effect that the rule shall not be deemed the basis for a private civil action and is not intended to increase the responsibilities of audit committee members under state law.
In light of the increased audit committee responsibilities and membership qualifications imposed by SOA, audit committee members have become concerned that they are being considered "super directors" or a "super committee." In particular, there are legitimate concerns that courts will, in light of the proposed audit committee listing standards, impose greater liability on audit committee members, as compared to other directors.1 We believe that the Commission should make it clear that the proposed rule will not have this effect.
The above concerns are similar to the concerns expressed to the Commission in connection with the proposed "audit committee financial expert" rule, which the Commission appropriately addressed by the inclusion of a liability safe harbor in the final rule.2 In particular, the Commission recognized concerns that the designation as audit committee financial expert may inappropriately suggest that such member bears greater responsibility and is therefore subject to a higher degree of liability for audit committee decisions. We believe that there is a similar danger at the entire audit committee level that courts may interpret the requirements of the proposed rule as imposing a higher standard of care for audit committee members than for other members of the board of directors. Such an outcome will have the unfortunate effect of further limiting the pool of qualified individuals willing to serve on audit committees, which will undermine the fundamental goal of Section 301 of ensuring strong and effective audit committees. Accordingly, we recommend that Rule 10A-3 include a provision expressly stating that the rule shall not be deemed to provide or create a basis for a private civil action and is not intended to increase the responsibilities of audit committee members under state law.
2. The rule should specify that SROs will have the ability to grant exemptions from their listing standards promulgated pursuant to the rule, consistent with current practice.
The Proposing Release requests comment on whether the self-regulatory organizations required to issue new listing standards under proposed Rule 10A-3 (the "SROs") should be permitted to grant exemptions from these new listing standards. The SROs currently have the ability in the appropriate circumstances to permit waivers from their corporate governance standards and we see no reason to treat the proposed listing standards differently.3
We believe that this is particularly appropriate since the SROs will be responsible for implementing and interpreting the proposed standards. The SROs' ability to grant waivers will permit them to respond to new and unforeseen issues as they arise. Further, in light of the unprecedented nature of the proposed standards, we recommend that the Commission give the SROs maximum flexibility to devise appropriate waivers.
II. Audit Committee Member Independence
1. The reference to "director" in the safe harbor exclusion from the definition of affiliate is confusing and does not appear to serve any purpose. In addition, the safe harbor should be extended to entities other than the issuer and should refer to beneficial ownership of any class of "voting equity securities" rather than any class of "equity securities."
The Proposing Release solicits comment on the definition of "affiliate" and "affiliated person," including the proposed safe harbor exclusion from the definition of affiliate for any person who is not the beneficial owner, directly or indirectly, of more than 10% of any class of equity securities of the issuer, an executive officer of the issuer and a director of the issuer. We do not understand the rationale for including "directors" in the definition's safe harbor, given that audit committee members will always be directors of the issuer. While the proposed rule's independence requirements are specifically limited by the phrase "other than in his or her capacity as a member of the audit committee, the board of directors or any other board committee" and presumably it is not the Commission's intention to deny the availability of this safe harbor to directors of the issuer, the inclusion in the safe harbor of "director" as a category creates the potential for significant confusion and uncertainty as to its application.
We also suggest that the Commission extend the safe harbor to entities other than the issuer. We expect that issues will arise as to the relationship between a director and an entity that the issuer is associated with. In such a case, we believe that the safe harbor will provide a useful bright-line rule; that is, the director will not be an "affiliated person" of the issuer merely because he or she is a director or a 10% or less beneficial owner of the other entity.
We also suggest changing the reference in paragraph (A) of the safe harbor from a beneficial owner of more than 10% of "any class of equity securities" of the issuer to "any class of voting equity securities." Since the safe harbor is intended to exempt certain individuals who cannot be deemed to control the issuer from the definition of "affiliate," it should also be available to a person who may own more than 10% of the issuer's non-voting equity, such as a class of preferred shares, but who cannot possibly be deemed to exercise control over the issuer by virtue of such ownership alone. This will be consistent with the determination of beneficial ownership under Sections 13(d) and 16 of the Exchange Act, both of which exclude non-voting equity securities from the beneficial ownership calculation. In particular, our suggested change would be consistent with the use of the Rule 13d-3(d)(1) standard to determine beneficial ownership.4
2. The irrebuttable presumption in the affiliated person definition providing that a director, executive officer, partner, member, principal or designee of an affiliate will be deemed an affiliate should be removed.
The definition of "affiliate" or "affiliated person" contains what appears to be an irrebuttable presumption that "[a] director, executive officer, partner, member, principal or designee of an affiliate will be deemed an affiliate." This irrebuttable presumption contrasts with the facts-and-circumstances analysis contemplated by the definition of "affiliate."
Under the proposed rule, the determination of affiliate status is premised on the notion of "control," which, as recognized in the Proposing Release, would require a factual determination based on all relevant facts and circumstances. By precluding such analysis, the presumption would prevent a number of persons who, in fact, do not control the issuer from serving on the issuer's audit committee. For instance, would any director (including an outside director or a member of the supervisory board of a non-U.S. issuer) of an affiliate be deemed an affiliate? Would a limited partner in a limited partnership that is an affiliate or a non-managing member of a limited liability company that is an affiliate also be precluded from serving on the issuer's audit committee? The presumption appears to us to cast too wide a net and will unfortunately catch audit committee members who clearly are not in "control" of the issuer or an affiliate of the issuer.
If the presumption in paragraph (e)(1)(ii) is retained, we suggest that it should be limited to situations where the audit committee member is an executive officer of the affiliate. As noted above, the presumption would appear to encompass outside directors, limited partners of a partnership and non-managing members of a limited liability company. None of these categories of persons appear to be in a "control" position. The presumption also picks up the undefined categories of "principal" and "designee." The scope of these terms is unclear to us. For instance, does the term "principal" refer to an agency relationship or a position in an organization? In any event, it appears to us that these terms should be subsumed within the definition of "executive officer." If retained, in our view, the presumption should focus on the ability of the audit committee member to make policy decisions for the affiliate; this focus is consistent with the definition of control.
As the Commission is aware, large shareholders have the ability in some cases to elect the entire board of directors. In such a case, an issue may arise as to whether each member of the audit committee is a "designee" of the large shareholder. Obviously, this was not the Commission's intent in including "designee" of an affiliate in paragraph (e)(1)(ii) of the proposed rule. Therefore, we suggest that the Commission clarify in the adopting release that the fact that a director has been elected by a large shareholder in-and-of itself would not cause the director to be a "designee" of the shareholder for purposes of paragraph (e)(1)(ii) of the rule as well as the exemptions provided by paragraphs (b)(1)(iv)(D) and (b)(1)(iv)(E).
3. The definition of "indirect acceptance" of a compensatory fee should be limited to entities in which an audit committee member is an "executive officer," rather than a "partner, member or principal," and should contain a de minimis exception.
The proposed rule defines "indirect acceptance" of a consulting, advisory or other compensatory fee to include acceptance of such a fee by an entity in which a member of the issuer's audit committee is "a partner, member or principal or occupies a similar position." As discussed above, we believe that the reference to "partner, member or principal" is overinclusive since it would apply to limited as well as general partners, non-managing as well as managing members and other persons who may not be deemed to control the particular entity. As with the affiliate definition, there is no reason to extend the prohibition of indirect compensation to an entity that the audit committee member does not control. While we support the Commission's intention to prohibit an audit committee member's indirect receipt of a compensatory fee from the issuer, we do not believe that payments to an entity which is not controlled by such member should be deemed to interfere with the member's exercise of independent judgment. Accordingly, we suggest that indirect acceptance be defined by reference to whether the audit committee member is an executive officer. This would, in our view, appropriately focus the definition on whether the audit committee member has the ability to influence the entity's business dealings with the issuer. In the absence of such influence, no policy purpose appears to be served by extension of the indirect compensation prohibition to these entities. Our proposal is consistent with the current NYSE and Nasdaq corporate governance standards. The current NYSE independence requirements for audit committee members require the board of directors to examine business relationships with an organization only if an audit committee member is a "partner, controlling shareholder or executive officer" of such organization; the Nasdaq rules provide that a director shall not be considered independent if the director is a "partner in, or a controlling shareholder, or executive officer of" an organization which made to or received from the issuer specified payments. Any concern that the Commission may have that our proposed "executive officer" standard will not appropriately cover arrangements where the audit committee member, while not an executive officer, has a significant financial interest in the entity may be addressed by requiring that the member not have a greater than 10% interest in the profits or capital of the other entity.
If the above approach is not acceptable to the Commission, then we suggest that the reference to "partner" and "member" in the "indirect acceptance" definition be limited to a general partner and managing member and that the reference to "principal" in the definition be eliminated due to its vagueness. We believe that this will be consistent with the proposed exemption since the "partner, member or principal" standard appears to be, at a minimum, aimed at relationships where the audit committee member serves in a management position.
The Proposing Release also requests comment on whether there should be an exception from the compensatory fee prohibition for a de minimis amount of payments. We believe that it would be appropriate to incorporate a de minimis exception in the "indirect acceptance" of compensatory fee prohibition with respect to entities which provide accounting, consulting, legal, investment banking, financial services or any similar services to the issuer. Clearly, certain payments will be so small in the context of such an entity's total revenues that they cannot possibly have any bearing on the independence of an audit committee member who occupies one of the specified positions in that entity. At the same time, if the "indirect acceptance" definition encompasses any fee to such entity it may have the effect of unduly restricting a listed company's ability to recruit qualified candidates for its audit committee, especially candidates with relevant accounting, financial or legal experience. In particular, in some countries, the market for the services enumerated in the proposed definition may be so limited that a U.S.-listed non-U.S. issuer may have varying degrees of business relationships with virtually all significant participants. Accordingly, we believe that a de minimis exception would appropriately focus the "indirect acceptance" definition only on an issuer's principal advisors. In this respect, we note that the Nasdaq independence standard prohibiting payment to or from an organization in which a director is a partner, controlling shareholder or executive officer applies only to payments that exceed 5% of the organization's consolidated gross revenue for that year, or $200,000, whichever is more.
4. Compensation under a retirement or similar plan in which a former officer or employee of the issuer participates should not be included in the definition of the term compensatory fee.
The Proposing Release requests comment on whether the rule should clarify if compensatory fees would include "compensation under a retirement or similar plan in which a former officer or employee of the issuer participates." We believe such compensation should not be included in the definition of the term "compensatory fee." This would be consistent with the New York Stock Exchange corporate governance rule proposals filed with the Commission as well as Nasdaq's independence requirements. The commentary to proposed Section 303A.6 of the NYSE Listed Company Manual provides that "[i]f a director satisfies the definition of "independent director" . . . , then his or her receipt of a pension or other form of deferred compensation from the company for prior service (provided such compensation is not contingent in any way on continued service) will not preclude him or her from satisfying the requirement that director's fees are the only form of compensation he or she receives from the company." The Nasdaq rules on director independence similarly contain an exemption for benefits under a tax-qualified retirement plan. We believe that an issuer's board of directors should have the flexibility to determine that the receipt of compensation for past service, as long as it is not contingent on future service, does not interfere with an audit committee member's independence. In addition, we believe that the experience and knowledge that former officers or employees can bring the audit committee can substantially increase the committee's ability to exercise its oversight function. Therefore, we urge the Commission to allow former employees who receive retirement payments from the issuer to serve on such issuer's audit committee by defining the term "compensatory fee" to specifically exclude any compensation under a retirement or similar plan in which a former officer or employee of the issuer participates.
5. The determination of whether an audit committee member is independent should be made by the issuer's board of directors.
The Proposing Release requests comment on whether the board of directors should determine whether an audit committee member is independent and if not, who should. We believe that the independence determination should be made by the board of directors of the listed company. This would also be consistent with the current and proposed NYSE and Nasdaq rules governing director independence which provide that the board of directors must determine that a director does not have any relationship that would interfere with his or her independence. It is important to make this clarification since, as discussed, the determination of whether an audit committee member meets the independence criteria would depend on a factual analysis and, in our view, the board of directors would be in the best position to perform this analysis.
6. The exemptions from the rule's requirements for holding companies and multiple listings are unnecessarily narrow and should be extended so that they are available to any subsidiary of a holding company and any entity that is supported by the holding company's credit.
We believe that the proposed limited exemption from the requirement that an audit committee member cannot be an affiliate of the issuer for members who serve on the audit committee of both a holding company and a "consolidated majority-owned" subsidiary is, in our view, an appropriate and necessary exercise of the Commission's authority under Section 301 to exempt particular relationships from the audit committee independence requirements. However, we believe that, as drafted, the proposed exemption is unnecessarily narrow. First, we believe that the proposed exemption should not be limited to "majority-owned" and "consolidated" subsidiaries. As an initial matter, it is unclear to us what relevance either majority ownership or consolidation have to a control analysis. Clearly, a company may be controlled by a parent company even if the parent owns less than 50% of the company's voting securities or is not required to consolidate the company under the accounting rules to which it is subject. Therefore, an exemption conditioned on a subsidiary's status as "consolidated" and "majority-owned" would operate in an arbitrary way and would impose a significant burden on holding companies which have overlapping boards of directors with one or more of their affiliates that do not meet these requirements. As recognized by the Proposing Release, the composition of the board of directors of a holding company and its subsidiaries is often similar given the control structure. Accordingly, we propose that the exemption be extended to any subsidiary of the holding company, defined by reference to Rule 12b-2 under the Exchange Act. Under this definition, "a subsidiary of a specified person is an affiliate controlled by such person directly, or indirectly through one or more intermediaries." Both "affiliate" and "control" are already defined in the proposed rule. We believe that making the exemption available to any subsidiary, as defined above, would be a logical and appropriate application of the Commission's statement in the Proposing Release that "[i]f an audit committee member of the parent is otherwise independent, merely serving also on the board of a controlled subsidiary should not adversely affect the board member's independence."
Secondly, we believe that the holding company exemption should be available to entities that are supported by a holding company's credit. In the case of an entity whose outstanding securities are fully and unconditionally guaranteed by the parent holding company, it seems clear that investors in the other entity's securities are looking to the audit committee of the parent holding company. This is especially the case where the entity is not filing periodic reports under the Exchange Act pursuant to Rule 3-10 of Regulation S-X. Accordingly, we believe that an entity whose outstanding securities (other than common equity securities) are fully and unconditionally guaranteed by a parent holding company should also be covered by the holding company exemption.
The preceding discussion would apply equally to the proposed "multiple listings" exemption contained in paragraph (c)(1) of the rule, which also applies only to subsidiaries of a listed issuer which are "consolidated" and "majority-owned." Accordingly, we believe that the multiple listings exemption should also be revised along the lines suggested above.
7. The exemption from the independence requirements for new public companies should be conformed to current market practice.
We agree with the Commission that the proposed exemption from the independence requirement for a non-investment company issuer after its initial public offering is appropriate and consistent with the purposes of Section 301. However, we believe that the exemption, which covers only one member of the audit committee and only for a period of 90 days, is too limited in scope to address the legitimate concerns regarding new public companies recognized in the Proposing Release. In particular, the release recognizes the difficulty of recruiting independent directors before an initial public offering, especially in times of market uncertainty when there is a significant risk that the offering will not be completed. A requirement that all but one member of the audit committee must be independent at the time of the company's initial public offering would pose a significant hurdle to privately held companies attempting to recruit independent directors in preparation for a contemplated initial public offering. The NYSE has developed a transition provision for audit committees to address these concerns that has the benefit of several years of experience. Under the NYSE transition provision, a company listing in conjunction with its initial public offering will be required to have two qualified audit committee members in place within three months of listing and a third qualified member in place within twelve months of listing. We urge the Commission to conform the proposed exemption to the existing NYSE exemption.
III. Procedures for Handling Complaints
1. The rule should clarify who may submit complaints to the audit committee and permit audit committees to receive a report on the types of complaints received.
The proposed rule does not clarify who may submit complaints to the issuer regarding accounting, internal accounting controls or auditing matters. As drafted, paragraph (b)(3)(i) of the rule could be read to allow complaints by vendors, customers and organizations representing these constituencies. We do not believe that the audit committee can, as a practical matter, or should, as a legal matter, review all "complaints" received from any possible constituency, including complaints filed by disgruntled employees. Such a requirement will have the potential of overwhelming audit committee members with frivolous complaints, distracting the audit committee from more important matters and unnecessarily involving the audit committee in day-to-day employer/employee disputes.
One purpose of Section 301 is to ensure active and effective audit committees. We believe that the breadth of the proposed rule may undermine this goal and accordingly suggest that the Commission should limit the universe of persons who may submit complaints to the audit committee, as well as allow the audit committee to review only a summary of complaints received, as discussed below. It seems to us that the group most likely to have legitimate accounting-related concerns are employees in the financial reporting area. While other employees and shareholders may also have legitimate accounting-related complaints, we believe that the likelihood that these complaints would actually lead to a financial reporting issue is outweighed by the additional potential burden placed on audit committee members. We are particularly concerned that the proposed rule may have the practical effect of elevating every employment dispute into an audit committee matter. Moreover, audit committee members simply do not have an unlimited amount of time to spend reviewing complaints from shareholders, vendors, suppliers and others.
In a similar vein, we also believe that the Commission should permit audit committee members to receive a report that provides a summary of the complaints received. To do otherwise may require audit committee members to review lengthy and perhaps rambling and incoherent e-mails and letters. As the Commission is aware, some shareholders have been known to submit Rule 14a-8 shareholder proposals that contain over 100 pages of materials.5 In order to encourage the most efficient use of audit committee time and resources, we suggest that the proposed rule be clarified to expressly permit audit committees to receive summaries of complaints. We note that, under the proposed rule, the audit committee will have the necessary funding and ability to hire advisors to pursue any potentially meritorious complaint.
2. The audit committee should be able to designate one or more administrative officers of the company to receive complaints.
If the Commission does not accept our proposal to permit audit committees to receive reports with respect to the type of complaints submitted, we recommend that the Commission clarify that the audit committee may utilize one or more administrative officers of the issuer for the purpose of receiving complaints. If the rule's requirement regarding complaint procedures is interpreted as requiring the audit committees to appoint outside persons or entities for the purpose of receiving complaints, this would add to the compliance costs that listed companies would face as a result of the rule's requirements. These costs would include time and expenditure associated with the search for an appropriate outside person or entity and such person's or entity's compensation. It does not appear that these additional costs would be justified by a corresponding benefit as long as the officer or officers designated by the audit committee perform simply administrative functions, such as compiling or organizing the complaints by category.
IV. Application and Implementation of the Proposed Standards
A. Securities Affected
1. Debt and non-convertible preferred securities should be added to the list of securities exempt from the rule's requirements.
The proposed rule's audit committee requirements apply as a result of the listing of "any security." As pointed out in the Proposing Release, this would include not only voting equity securities but also debt and other types of listed securities, except for the very limited exceptions contained in paragraph (c) of the rule. However, different listing standards have always applied to the listing of debt securities and non-convertible preferred stock as opposed to common stock. For instance, the existing New York Stock Exchange corporate governance standards specify that they apply only to companies listing common stock on the NYSE. We believe that it is important to read Section 301 of SOA in the context of this historical distinction. In addition, it seems to us that Section 301 implicitly assumes that the members of the audit committee of a listed company will have fiduciary duties to the holders of its securities. However, under most state laws, directors generally have no fiduciary duties to the holders of debt securities or non-convertible preferred stock. The Proposing Release states that investors in an issuer's fixed income securities would also benefit from the increased financial oversight resulting from a strong and effective audit committee. However, we would point out that these investors have the ability to negotiate for such protections as they may deem necessary. Accordingly, we believe that the listing of debt or non-convertible preferred securities should be added to the exemptions contained in paragraph (c) of the rule.
Even if the Commission does not accept our suggestion, we would recommend that, at a minimum, the rule should exempt debt securities of issuers registered under Schedule B. While such securities would not typically be listed, there would seem to be no reason to preclude the possibility of such listings on account of an audit committee requirement that is plainly inapplicable to the type of issuers that qualify for registration on Schedule B. Paragraph (c) of the rule should therefore contain an additional exemption for securities of issuers registered under Schedule B.
B. Non-U.S. Issuers
1. Instruction 1 to the rule should be expanded to cover potential conflicts with foreign corporate governance arrangements in the areas of auditor retention and compensation and recommendations or nominations regarding auditor appointment.
Instruction 1 to the proposed rule clarifies that the rule does not conflict with, and does not affect the application of, (1) any requirement under the issuer's governing law or documents or other home country requirements that requires shareholders to ultimately elect, approve or ratify the selection of the issuer's auditor or (2) any requirement in the home jurisdiction that prohibits the full board of directors from delegating the responsibility to select the company's auditor. In the Proposing Release, the Commission requested comment on whether there are any additional areas in which the proposed rule would be inconsistent or inappropriate in a significant way with foreign corporate governance arrangements.
While Instruction 1 addresses the most significant conflicts arising from the prescribed responsibilities of the audit committee with respect to the issuer's auditor, it does not address potential conflicts that may arise from the requirement that the audit committee must be responsible for the outside auditor's compensation and retention, which, as noted in the Proposing Release, includes the power not to retain (or to terminate) the outside auditor. In particular, potential conflicts may arise as a result of the authority of shareholders under applicable laws to determine the auditor's compensation in some jurisdictions, such as the United Kingdom, Sweden, Norway and Italy, and to remove or terminate the appointment of the auditor as well as governing documents of non-U.S. issuers that vest such responsibilities with shareholders or the board of directors. In addition, the instruction only addresses conflicts arising from home jurisdiction requirements prohibiting the board of directors from delegating the power to select the outside auditor. It does not, however, specifically address a potential conflict with legal requirements in some jurisdictions, such as Germany, that prohibit the board of directors from delegating its power to make nominations or recommendations, which would include nominations or recommendations with respect to the appointment of the outside auditor. Some jurisdictions, such as Germany, also allow shareholders to make counter-proposals for the appointment of the outside auditor, in addition to any right that the board of directors may have to make nominations or recommendations. Therefore, we suggest that Instruction 1 be expanded to clarify that the rule's requirements will not conflict with (1) approval of the auditor's compensation or removal of the auditor by the shareholders, (2) legal requirements prohibiting the board of directors from delegating such approval or generally delegating the power to make recommendations or nominations, or (3) legal requirements allowing shareholders to make counter-proposals regarding the appointment of the auditor.
Furthermore, in some jurisdictions, including Germany and France, the outside auditor can be removed prior to the expiration of its term only by a court order under specified circumstances, upon the application of specified bodies, such as shareholders. These specified circumstances are quite narrow, which is consistent with the underlying purpose of the auditor removal requirements to protect the auditor's independence. Accordingly, in these jurisdictions there will be a potential conflict with the requirement that the audit committee be directly responsible for the termination of the auditor's appointment and it may be in fact very difficult for the outside auditor to be removed prior to the expiration of its term of appointment. Therefore, we propose that the Commission add an additional clarification in Instruction 1 to the effect that the requirement that the audit committee must be directly responsible for the retention of the outside auditor, as clarified by the instruction, shall be deemed satisfied by the ability to recommend against the auditor's reappointment at the end of its term.
These additional clarifications would also be consistent with the purposes of Section 301 since they would accommodate a foreign corporate governance arrangement designed to protect the auditor's independence, and since, as stated in Instruction 1 to the proposed rule, the requirement that the audit committee must have sole responsibility over the appointment, compensation, retention and oversight of the auditor relates to the assignment of responsibility as between the audit committee and management.
2. The exemption for controlling shareholders of non-U.S. issuers should be expanded in light of the recognized concerns regarding foreign corporate governance arrangements.
We believe that the Commission's proposed exemption for controlling shareholders or shareholder groups of non-U.S. issuers is an appropriate exercise of the authority granted to the Commission to exempt particular relationships from the independence requirements of Section 301. As noted in the Proposing Release, such controlling shareholders are more prevalent among non-U.S. issuers than in the United States and have traditionally played a more prominent role in corporate governance. In addition, we believe that such shareholders or their representatives can make a substantial contribution to the work of the audit committee due to their knowledge of the industry and the listed company. They also have a compelling interest to exercise oversight over the individuals serving in management and the financial reporting process. Accordingly, we believe that the proposed exemption should be modified to allow such shareholder or the representative of such shareholder or group of shareholders to be a voting member of the audit committee.
In addition, as discussed in our comment above with respect to the exemption for holding companies, defining control as the ownership of more than 50% of the issuer's voting common equity may have the benefit of a bright line rule but is arbitrary insofar as it would deny the benefit of the exemption to shareholders or shareholder groups who similarly exercise effective control over an issuer without owning more than 50% of the issuer's voting equity. As noted, a smaller shareholding may be sufficient to confer control over the issuer and, particularly in non-U.S. jurisdictions, a number of other factors can affect the ability of a shareholder to exercise control. For instance, in countries where proxy solicitation by management is prohibited or severely restricted by law or otherwise limited in practice, a significantly smaller shareholding may be sufficient to confer control over an issuer. As discussed above, the proposed rule's definition of control will provide the necessary flexibility to ensure that controlling shareholders of non-U.S. issuers can equally take advantage of the exemption. Accordingly, we urge the Commission to amend this exemption so it is available to any shareholder or group of shareholders which is an affiliate of the issuer. This would also make the proposed controlling shareholder exemption consistent with the proposed exemption for a representative or designee of a non-U.S. government.
3. The rule should allow supervisors of certain non-U.S. issuers to serve on such issuers' audit committees along with members of the board of directors.
The proposed rule contains a rule of construction requiring an issuer with a two-tier board of directors to deem references to the term "board of directors" (for purposes of the rule) to mean the supervisory or non-management board. This would seem to be tailored to certain European corporate governance regimes, but does not address the corporate governance structures in certain other jurisdictions, including Taiwan. We believe that this provision should be expanded to address the circumstances of non-U.S. issuers which, under applicable home country laws, have a different corporate governance structure than the European structure apparently contemplated by the proposed rule. Some of these corporate governance structures include supervisors that function as individuals (and not as a board), alongside a board of directors that consists of both management and other non-independent directors as well as one or more independent directors. In Taiwan, for example, companies must have supervisors, who act in their individual capacity (and not as a board) and who are required under Taiwan's Company Law to supervise the finances and business of the company, including undertaking a review of the company's annual financial statements. These supervisors are separate from the board of directors, must not be officers, directors or staff members of the company and must satisfy statutory independence requirements. We believe that the appointment of one or more of these supervisors to a Taiwanese issuer's audit committee, in addition to one or more independent members of the issuer's board of directors, would be fully consistent with the purposes of Section 301. Accordingly, we propose that paragraph (e)(2) of the proposed rule should also allow non-U.S. issuers which have non-director supervisors that are subject to statutory independence requirements to deem references to the term "board of directors" (for purposes of the rule) to include both the board of directors and the supervisors.
4. The exemption for board of auditors or statutory auditors should be clarified to address an inconsistency regarding auditor compensation responsibilities and to accommodate certain additional situations that fall within the purpose of the exemption.
As drafted, the general exemption for an issuer which has a board of auditors (or similar body) or statutory auditors in paragraph (c)(2) of the rule applies to paragraphs (b)(1) and (b)(2), but not to paragraphs (b)(3), (b)(4) and (b)(5) of the rule. Paragraph (b)(2)(i), from which a non-U.S. issuer relying on (c)(2) will be exempt, includes the requirement that the audit committee must be directly responsible for the compensation of the outside auditor. At the same time, paragraph (b)(5)(i), from which such issuer's board of auditors (or similar body) will not be exempt, assumes that the audit committee or, in this case, the board of auditors (or similar body) will determine the "payment of compensation" of the outside auditor. In order to address this inconsistency, we propose that that paragraph (c)(2)(i) of the rule be amended to add paragraph (b)(5)(i) to the list of requirements from which a non-U.S. issuer relying on the exemption will not be subject and that accordingly paragraph (c)(2)(ii) of the rule should refer only to paragraph (b)(5)(ii).
We also believe that the exemption in paragraph (c)(2) of the rule should be available to a non-U.S. issuer even if the body performing the described functions is not separate from the issuer's board of directors, as long as such body meets all other requirements of the exemption. In particular, as mentioned in footnote 88 in the Proposing Release, Japanese companies, who have boards of auditors and would be eligible to avail themselves of this exemption, will have the option of electing instead a system based on nominating, audit and compensation committees effective April 1, 2003. However, notwithstanding the similarity in the designation of these committees, the Japanese committee-based corporate governance system will be different from the corporate governance system in the United States or other countries. In particular, the Japanese-style audit committee will be subject to, and bound by, a set of Japanese legal requirements that are different in some respects from the audit committee requirements of the rule. At the same time, the Japanese-style "audit committee" will, more or less, have the auditor oversight functions that the board of statutory auditors has. Thus, Japanese companies that adopt the committee-based corporate governance system will be in the same situation as Japanese companies with statutory auditors, with respect to the conditions for using the general exemption provided by paragraph (c)(2). Accordingly, we propose that paragraph (c)(2)(i)(B) be amended to remove the phrase "separate from the board of directors."
In addition, we believe that the exemption provided by paragraph (c)(2) of the rule should be made available to non-U.S. issuers even if they are not listed on a securities exchange outside of the United States as long as they otherwise satisfy the requirements of paragraph (c)(2). While the audit committee requirements that an issuer is subject to in the United States and other countries depend on whether the issuer is listed on a securities exchange and the requirements of the particular exchange, in Japan currently the standards for auditor oversight applicable to statutory auditors are determined by the size of the company's assets or liabilities. If, due to the size of its assets or liabilities, a company meets the criteria as a "large corporation" under Japanese corporation law, the highest standards for auditor oversight apply to the company. Accordingly, large Japanese companies with corporate statutory auditors will meet the prescribed auditor oversight standards of the exception regardless of whether they are listed in Japan or not. In light of the above, we believe that paragraph (c)(2)(i)(A) of the rule should be amended to add the following language at the end of the paragraph: ", or the foreign private issuer meets corporate governance requirements regarding the appointment, retention and oversight of the work of any public accounting firm equivalent to the requirements regarding such matters applied to issuers which are listed or quoted on a securities exchange or inter-dealer quotation system in the home country."
Finally, as discussed in more detail below, we believe the rule of construction in paragraph (c)(2)(ii) of proposed Rule 10A-3 should also apply to the auditor independence rules and the audit committee financial expert disclosure rules so that for purposes of non-U.S. issuers relying on the exemption of paragraph (c)(2) of Rule 10A-3, the term audit committee, as used in these rules, will refer to such issuer's board of auditors (or similar body) or its statutory auditors.
C. Investment Companies
1. We agree with the Commission that the rule should not apply to non-listed registered investment companies.
The proposed rule covers closed-end investment companies with securities listed on an SRO and exchange-traded open-end investment companies but not other open-end investment companies. While the auditor independence rules, including provisions on audit committee administration of the auditor's engagement, apply to all registered investment companies, Rule 10A-3 should not apply to non-listed registered investment companies consistent with Section 301 of SOA. We also agree that exchange-traded unit investment trusts should be excluded from the proposed requirements.
V. Proposed Disclosures Regarding Audit Committees
1. The requirement to disclose reliance on any exemptions from the rule and how such reliance would materially adversely affect the ability of the audit committee to act independently would not result in any meaningful disclosure and should be eliminated.
The proposed rule contains a requirement to disclose reliance on any exemptions from the rule and how such reliance would materially adversely affect the ability of the audit committee to act independently and satisfy the other requirements of the proposed rule. This provision exceeds the requirements of Section 301 and we believe that it would not result in any meaningful disclosure to investors. As noted in the Proposing Release, the Commission has not proposed any broad exemptions from the rule's independence and other requirements, such as a blanket exemption for non-U.S. issuers. On the contrary, the proposed exemptions are narrowly tailored to address specific situations, such as particular conflicts with foreign corporate governance requirements, the need to provide a transition for new public companies or the inapplicability of the rule to certain types of securities. Furthermore, as discussed in the release, these narrow exemptions are not inconsistent with Section 301's purpose of ensuring the independence of a public company's audit committee from management and its exercise of effective oversight over the financial reporting process. Accordingly, the proposed disclosure of an issuer's reliance of any of the exemptions in the issuer's annual report and proxy or information statement would not result in the inclusion in these reports of any information that is material to shareholders.
Moreover, it is unclear to us how an issuer can make the determination whether reliance on a particular exemption would materially adversely affect the ability of the issuer's audit committee to act independently and satisfy the other requirements of the proposed rule. The required determination would appear to require the issuer to compare the behavior of its audit committee to the behavior of a hypothetical "model" audit committee. This would obviously not be feasible since no such model exists and one size does not fit all in the context of audit committees. As stated in the Report and Recommendation of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, "[s]ince each company has its own unique circumstances _ type of business, industry, competitive environment, stage in the business cycle and business risks _ audit committee practices will vary naturally." Accordingly, we believe that this disclosure requirement, which is not mandated by Section 301, is not subject to practical application and should be removed from the proposed rule.
If the disclosure requirement is retained, then we urge the Commission to reconsider the list of exemptions included in paragraph (d) of the proposed rule, which are not subject to the disclosure requirement. In particular, we urge the Commission to exempt non-U.S. issuers from the disclosure requirement. We believe that investors who purchase securities of non-U.S. issuers do so with the expectation that such issuers will have different corporate governance arrangements that are appropriate in the context of their legal and historical circumstances. As discussed above, the exemptions in the rule accommodating such foreign corporate governance arrangements are narrowly tailored to address specific situations and therefore we do not believe that disclosure regarding reliance on such exemptions would be meaningful to investors. We recognize that the Commission has declined requests to exempt non-U.S. issuers from the audit committee financial expert and code of ethics disclosure requirements of Sections 406 and 407 of SOA. However, we stress that while Section 301 specifically grants to the Commission exemptive authority, it does not require disclosure of any such exemptions. In addition, if the disclosure requirement is retained, we believe that the adopting release should clarify that reliance on the instructions to the rule does not constitute reliance on an exemption for purposes of the required disclosure.
VI. Provisions of the Final Auditor Independence Rules Regarding Audit Committees
1. The final auditor independence rules should be harmonized with Rule 10A-3 with respect to audit committees.
On January 28, 2003, the Commission adopted final amendments to its auditor independence requirements.6 We believe that the provisions relating to audit committees contained in the final auditor independence rules should be harmonized with Rule 10A-3. In particular, we believe that the following provisions should be consistent in the final auditor independence rules and Rule 10A-3:
- Definition of independence. Section 202 of SOA and Rule 2-01(c)(7) of Regulation S-X require an issuer's audit committee to pre-approve all audit and non-audit services. As provided in Section 202 and as discussed in the Auditor Independence Release, an audit committee may delegate pre-approval authority to one or more audit committee members who are "independent" directors. Neither SOA nor the Auditor Independence Release defines the term "independent." We believe that "independent" should be defined for purposes of Section 202 of SOA and the rules adopted thereunder in the same way as the term is defined in proposed Item 7(d)(3)(iv) of Schedule 14A (which refers to the independence definition included in the listing standards applicable to the issuer or, in the case of non-listed issuers, selected by the issuer for the purpose of making the independence determination).
- Definition of "audit committee." Rule 2-01 of Regulation S-X, as amended by the final auditor independence rules, specifically adopts the statutory definition of the term "audit committee" in Section 3(a)(58) of the Exchange Act. In contrast, while the Proposing Release refers to the statutory definition, such as to clarify that, in accordance with this definition, the new SRO rules will apply to the entire board of directors of an issuer in the absence of an audit committee, proposed Rule 10A-3 does not expressly define the term "audit committee." We believe that the Commission should adopt a single definition of the term "audit committee" in these areas or at least clarify that any interpretation of the term for purposes of Rule 10A-3 would also apply for purposes of the rules adopted under the Auditor Independence Release.7
- Application to non-U.S. issuers. The final auditor independence rules do not have a provision similar to paragraph (c)(2)(ii) of proposed Rule 10A-3, which allows companies with corporate statutory auditors or similar bodies to deem references to "audit committee" in the rule to refer to such statutory auditors, or paragraph (e)(2) of proposed Rule 10A-3, which provides that, in the case of non-U.S. issuers with two-tier boards, the term board of directors means the supervisory or non-management board. These rules of construction would appear to be of equal applicability and we recommend that the Commission clarify that they will have the same application in applying and interpreting the rules adopted under the Auditor Independence Release.
VII. Audit Committee Financial Expert Disclosure Rules
1. To the extent the audit committee financial expert disclosure requirements will apply to a non-U.S. issuer with a board of auditors (or similar body) or statutory auditors, the rules should clarify that the relevant corporate body for purposes of the required disclosure is the issuer's board of auditors (or similar body) or statutory auditors.
The Audit Committee Financial Expert Release requests comment on whether the audit committee financial expert disclosure requirements, to the extent such requirements will apply to a non-U.S. issuer with a board of auditors (or similar body) or statutory auditors, should apply to the board of auditors (or similar body) or statutory auditors. As noted above, the corporate governance standards of certain foreign jurisdictions, such as Japan, require a board of auditors (or similar body) or statutory auditors to exercise financial oversight with respect to a public company comparable to the oversight typically exercised by an audit committee of a U.S. issuer. To the extent that the requirements apply to such issuers, it would be appropriate for such body as the board of auditors of the issuer to determine whether any of the members of the body meet the requirements of an "audit committee financial expert" and make the required disclosure. Accordingly, as noted above with respect to our comment on the application of the rules adopted under the Auditor Independence Release to non-U.S. issuers, we recommend that the audit committee financial expert disclosure rules contain a rule of construction similar to paragraph (c)(2)(ii) of proposed Rule 10A-3, which allows non-U.S. issuers with a board of auditors (or similar body) or statutory auditors to deem references to "audit committee" in the rules to refer to such body.
2. To the extent the financial expert disclosure requirements will apply to a non-U.S. issuer with a board of auditors (or similar body) or statutory auditors, the rules should permit the use of applicable independence standards under home country legal or listing provisions for such issuer's independence disclosure.
The Audit Committee Financial Expert Release requests comment on whether an issuer with a board of auditors (or similar body) or statutory auditors should be permitted to use independence standards that apply to such body under home country legal or listing provisions for its independence disclosure. We believe that such issuers should be subject to only one independence standard, which should be the applicable standard under home country legal or listing provisions in order to give appropriate deference to foreign corporate governance standards that apply to such issuers. Proposed Rule 10A-3(c)(2) under Section 301 of SOA would exempt a non-U.S. issuer with a board of auditors (or similar body) or statutory auditors under home country legal or listing provisions from the independence requirements of proposed Rule 10A-3(b)(1) and (2), if, among other conditions, such issuer is subject to home country legal or listing provisions that set forth standards for the independence of such board (or body) or statutory auditors from the non-U.S. issuer or the management of such issuer. We recommend that the audit committee financial expert rules follow the approach of proposed Rule 10A-3(c)(2) and permit a non-U.S. issuer with a board of auditors (or similar body) or statutory auditors to use for its independence disclosure applicable independence standards under home country legal or listing provisions.
* * *
We appreciate the opportunity to comment to the Commission on the proposed rule, and would be pleased to discuss any questions the Commission may have with respect to this letter. Any questions about this letter may be directed to John T. Bostelman (212-558-3840), David B. Harms (212-558-3882) or Robert W. Reeder III (212-558-3755) in our New York office, Kathryn A. Campbell (011-4420-7959-8580) in our London office, David B. Rockwell (011-4969-7191-2633) in our Frankfurt office or Izumi Akai (011-813-3213-6145) in our Tokyo office.
Very truly yours,
SULLIVAN & CROMWELL LLP
cc: Giovanni P. Prezioso
General Counsel
Alan L. Beller
Director, Division of Corporation Finance
Paul F. Roye
Director, Division of Investment Management
Annette L. Nazareth
Director, Division of Market Regulation
____________________________
| 1 | See, e.g., In re Lernout & Hauspie Securities Litigation, 286 B.R. 33 (D. Mass. 2002) (holding that an audit committee member may have liability as a control person under Section 20(a) of the Securities Exchange Act of 1934 (the "Exchange Act") based on, inter alia, (1) the audit committee's ability to retain accounting and legal advisors to investigate alleged accounting improprieties; (2) the audit committee's access to the issuer's financial information; and (3) the audit committee's frequent meetings with the outside auditors to discuss the issuer's financial reporting).
| | 2 | Final Rule: Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley Act of 2002, Release Nos. 33-8177, 34-47235, 68 Fed. Reg. 5110 (Jan. 31, 2003)(the "Audit Committee Financial Expert Release").
| | 3 | For instance, under its corporate governance rules, the New York Stock Exchange ("NYSE") has the authority to permit listing by companies with concentrated shareholdings (NYSE Listed Company Manual, Section 305), permit shareholder approval by consent instead of a meeting (NYSE Listed Company Manual, Section 306), approve certain defensive tactics, including potential discrimination among shareholders (NYSE Listed Company Manual, Section 308), and permit the quorum required for a shareholder meeting to be less than a majority of outstanding shares (NYSE Listed Company Manual, Section 310). Similarly, the Nasdaq Stock Market, Inc. ("Nasdaq") can grant exceptions from its shareholder approval requirements (NASD Manual, Rule 4350(i)(2)) and its voting rights policy (NASD Manual, Rule IM-4351).
| | 4 | See Rule 13d-1(i) under the Exchange Act.
| | 5 | See, e.g., American International Group, Inc., SEC No-Action Letter, 2002 WL 833651 (Jan. 15, 2002) (the letter indicates that the shareholder proposal discussed therein encompassed more than 150 pages of materials).
| | 6 | Final Rule: Strengthening the Commission's Requirements Regarding Auditor Independence, Release Nos. 33-8183, 34-47265, IC-25915, 68 Fed. Reg. 6006 (Feb. 5, 2003)(the "Auditor Independence Release").
| | 7 | This would include, for example, the rules relating to the administration of engagements with the independent auditors, employment of former auditors and communications between the independent auditors and the audit committee.
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