The following comments from Testa Hurwitz & Thibeault attorneys are worth considering.

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

Proposals Applicable to All Listed Companies, Regardless of Market Cap

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:

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.

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