CONTEMPLATING SERVING ON A BOARD'S AUDIT COMMITTEE?
The following comments from Testa Hurwitz & Thibeault attorneys are
Brian and Lori can be contacted at 617-248-7000.
Audit Committees Under Scrutiny
SEC Looks to Outside Directors to End "Earnings Management" Brian
E. Pastuszenski Lori A. Mihalich The SEC has indicated that it intends to
subject corporate audit committees of publicly traded companies to increased
scrutiny. Concerned by significant restatements of revenues and earnings by
major corporations (including Cendant Corp. and Waste Management Corp.), SEC
Chairman Arthur Levitt declared last September that the pressure to meet or
beat Wall Street earnings expectations has eroded the quality of financial
reporting. Levitt commented that "qualified, committed, independent and
tough-minded audit committees" are essential to combating an increasing
trend of such "earnings management." Levitt then challenged the
financial community to develop a "series of far-ranging recommendations
intended to empower audit committees" so that they could "function as
the ultimate guardian of investor interests and corporate accountability."
In response to Levitt's challenge, the New York Stock Exchange (NYSE), the
National Association of Securities Dealers (NASD) and the accounting profession
formed the Blue Ribbon Committee on Improving the Effectiveness of Corporate
Audit Committees. On February 8, 1999, the Blue Ribbon Committee released its
audit committee report. The report recommends a number of changes in NYSE and
NASD listing requirements, Generally Accepted Auditing Standards (GAAS) and SEC
disclosure requirements - all with an eye to making audit committees more
proactive and more effective corporate watchdogs.
Some of the recommendations are quite onerous; others less so. The Blue
Ribbon Committee's report recognizes that certain of its recommendations
(relating to audit committee member independence) may be too burdensome for
small-cap companies. For that reason, a $200 million market capitalization
threshold is suggested for those recommendations. While the report's
recommendations are not binding on any company, the SEC and the exchanges will
likely issue extensive new rules to implement those recommendations. The
report's principal recommendations are summarized below.
Proposals Applicable to Listed Companies with Market Caps over $200 Million
Change NYSE/NASD listing requirements to require that audit committees be
comprised solely of independent directors (a minimum of three). The proposed
definition of "independence" is quite restrictive: · Being an
outside, non-management director would not necessarily qualify as independence.
Being an officer, controlling shareholder or partner in any for-profit
business from which the company received "significant" payments
within the preceding five years would compromise a director's independence.
All audit committee members would have to be "financially
literate" - i.e., able to read and understand the company's financial
In addition, at least one member would be required to have "accounting
or related financial management expertise."
Proposals Applicable to All Listed Companies, Regardless of Market Cap
NYSE/NASD listing requirements should require audit committees to adopt
detailed, written charters that specify the scope of the committee's
responsibilities. Each company would be required to disclose in its annual
proxy statement whether the audit committee had adopted a written charter and
whether it had satisfied its responsibilities under the charter.
Under amendments to GAAS, outside auditors would no longer merely sign off
on the company's accounting practices as technically acceptable. Rather, they
would engage the audit committee in a substantive discussion of the quality of
the company's accounting practices. That discussion would include, among other
things: · The aggressiveness or conservatism of the company's accounting
The auditors' assessment of any estimates or other judgment calls made by
the company in the preparation of its financials. · SEC reporting rules
would be amended to require companies to include in their annual 10-K reports a
letter from the audit committee stating whether:
The committee had reviewed the financial statements with management.
The committee had been provided with the outside auditors' judgments as to
the quality of management's accounting principles.
The committee had discussed independently (and without management or
outside auditors present) the committee.
The audit committee believes the company's financials conform with GAAS.
SEC rules would be amended to require a company's outside auditors to
conduct an interim financial review prior to the filing of the company's 10-Q
report and to discuss the results of the review with the audit committee.
Recommendations for Immediate Action
The plaintiffs' class action securities lawyers will undoubtedly try to use
the Blue Ribbon Committee's report as ammunition if companies fail to reform
their audit committee practices as suggested in the report. We are also likely
to see an increase in the number of shareholder derivative actions challenging
whether audit committees have discharged their duty of due care to their
companies. Consequently, boards of directors should take immediate steps to
ensure that their audit committees function properly.
Good practices that will help audit committees and their members reduce
their risk profile including the following:
Hold audit committee meetings regularly- no less frequently than each
quarter, prior to release of the company's financial results.
Keep official minutes of all audit committee meetings and circulate them to
the full board of directors so that there is a record of all audit committee
Follow-up on any "red flags" that come to the audit committee's
attention and document the investigation of all red flags. Be mindful of notes
that are taken during audit committee meetings which may indicate that the
committee has identified, but not followed up on, red flags.
Thoroughly question the company's outside auditors regarding the quality of
the company's financial accounting practices (and the extent of the auditors'
own audit procedures), even when the auditors fail to identify any weaknesses
in company systems and controls.
Finally, board members who represent private equity investors should
consider carefully the increased commitment and, in all likelihood, the
increased exposure to liability before agreeing to serve on a public portfolio
company's audit committee.