[Federal Register Volume 64, Number 198 (Thursday, October 14, 1999)]
[Proposed Rules]
[Pages 55648-55662]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-26791]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 210, 228, 229, and 240
[Release No. 34-41987; File No. S7-22-99]
RIN 3235-AH83
Audit Committee Disclosure
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission is proposing new rules
and amendments to its current rules to improve disclosure related to
the functioning of corporate audit committees and to enhance the
reliability and credibility of financial statements of public
companies.
DATES: Public comments are due on or before November 29, 1999.
ADDRESSES: Please send three copies of your comment letter to Jonathan
G. Katz, Secretary, U.S. Securities and Exchange Commission, 450 Fifth
Street, NW., Washington, DC 20549-0609. Comment letters can be sent
electronically to the following e-mail address: rule-comments@sec.gov.
Your comment letter should refer to File No. S7-22-99; if e-mail is
used, please include the file number in the subject line. Anyone can
inspect and copy the comment letters in the Commission's Public
Reference Room, 450 Fifth Street, NW., Washington, DC 20549.
Electronically submitted comment letters will be posted on the
Commission's internet web site (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT: Mark Borges, Attorney-Adviser,
Division of Corporation Finance (202-942-2900), Meridith Mitchell,
Senior Counselor, Office of the General Counsel (202-942-0900), or W.
Scott Bayless, Associate Chief Accountant, or Robert E. Burns, Chief
Counsel, Office of the Chief Accountant (202-942-4400).
SUPPLEMENTARY INFORMATION: The Commission is proposing amendments to
Rule 10-01 of Regulation S-X,\1\ Rule 310 of Regulation S-B,\2\ and
Item 7 of Schedule 14A \3\ under the Securities Exchange Act of 1934
(the ``Exchange Act'').\4\ Additionally, the Commission is proposing
new Item 306 of Regulation S-K \5\ and Item 306 of Regulation S-B.\6\
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\1\ 17 CFR 210.10-01.
\2\ 17 CFR 228.310.
\3\ 17 CFR 240.14a-101.
\4\ 15 U.S.C. 78a et seq.
\5\ 17 CFR 229.306.
\6\ 17 CFR 228.306.
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I. Executive Summary
We are proposing new rules and amendments to current rules to
improve disclosure relating to the functioning of corporate audit
committees and to enhance the reliability and credibility of financial
statements of public companies. The proposals are based in large
measure on recommendations recently made by the Blue Ribbon Committee
on Improving the Effectiveness of Corporate Audit Committees (the
``Blue Ribbon Committee'').\7\
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\7\ See Report and Recommendations of the Blue Ribbon Committee
on Improving the Effectiveness of Corporate Audit Committees (1999)
(the ``Blue Ribbon Report''). The Blue Ribbon Report is available on
the internet at http://www.nasd.com and http://www.nyse.com.
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The Blue Ribbon Committee's work was designed to promote quality
financial reporting. Underpinning the Blue Ribbon Committee's work ``is
the recognition that quality financial accounting and reporting can
only result from effective interrelationships among'' corporate boards,
audit committees, senior and financial management, the internal auditor
and the outside auditors.\8\ Among these corporate participants, the
Blue Ribbon Committee's focus was on improving the effectiveness of
corporate audit committees. As the Blue Ribbon Committee said, the
audit committee is ``first among equals'' in the financial reporting
process \9\ because it is an extension of the full board, which is the
ultimate monitor of the process.
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\8\ Letter from the Chairmen of the Blue Ribbon Committee to
Messrs. Grasso and Zarb, Blue Ribbon Report, at 3.
\9\ Blue Ribbon Report, supra note 7, at 7.
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Audit committees play a critical role in the financial reporting
system by overseeing and monitoring management's and the independent
auditors' participation in the financial reporting process. An audit
committee can facilitate communications between a company's board of
directors, its management, and its internal and independent auditors. A
properly functioning audit committee helps to enhance the reliability
and credibility of financial disclosures.
We have seen a number of significant changes in our markets, such
as technological developments and increasing pressure on companies to
meet earnings expectations,\10\ that make it ever more important for
the financial reporting process to remain disciplined
[[Page 55649]]
and credible.\11\ We believe that additional disclosures about a
company's audit committee and its interaction with the company's
auditors and management will promote investor confidence in the
integrity of the financial reporting process. In addition, increasing
the level of scrutiny by independent auditors of companies' quarterly
financial statements should lead to fewer year-end adjustments, and,
therefore, more reliable financial information about companies
throughout the reporting year.
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\10\ See, e.g., Jack Ciesielski, Editorial, More Second-
Guessing: Markets Need Better Disclosure of Earnings Management,
Barrons, Aug. 24, 1998, at 47.
\11\ The Commission recently filed 30 enforcement actions
against 68 individuals and companies for fraud and related
misconduct in the accounting, reporting, and disclosure of financial
results by 15 different public companies. See SEC Press Release 99-
124 (Sept. 28, 1999).
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Accordingly, today's proposals would:
require that companies' independent auditors review the
financial information included in the companies' Quarterly Reports
on Form 10-Q or 10-QSB prior to the companies filing such forms with
the Commission (see Section III.A below);
require that companies include reports of their audit
committees in their proxy statements; in the report, the audit
committee must state whether the audit committee has: (i) Reviewed
and discussed the audited financial statements with management; (ii)
discussed with the independent auditors the matters required to be
discussed by Statement on Auditing Standards No. 61,\12\ as may be
modified or supplemented; \13\ and (iii) received certain
disclosures from the auditors regarding the auditors' independence
as required by the Independence Standards Board Standard No. 1, as
may be modified or supplemented,\14\ and discussed with the auditors
the auditors' independence (see Section III.B below);
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\12\ See Codification of Statements on Auditing Standards, AU
Sec. 380 (``SAS 61'').
\13\ See Exposure Draft for Proposed Statement on Auditing
Standards: Amendments to Statements on Auditing Standard No. 61,
Communication with Audit Committees and Statements on Auditing
Standard No. 71, Interim Financial Information (Oct. 1, 1999) (``ASB
Exposure Draft''). A copy of the ASB Exposure Draft can be obtained
at www.aicpa.org/members/div/auditstd/drafts.htm.
\14\ Independence Standards Board Standard No. 1, Independence
Discussions with Audit Committees (``ISB Standard No. 1''). A copy
of ISB Standard No. 1 can be obtained at www.cpaindependence.org.
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require that the report of the audit committee also
include a statement by the audit committee whether, based on such
review and discussions, anything has come to the attention of the
members of the audit committee that caused the audit committee to
believe that the audited financial statements included in the
company's Annual Report on Form 10-K or 10-KSB, as applicable, for
the year then ended contain an untrue statement of material fact or
omit to state a material fact necessary to make the statements made,
in light of the circumstances under which they were made, not
misleading (see Section III.B below);
require that companies disclose in their proxy
statements whether their audit committee has adopted a written
charter and, if the audit committee has adopted a charter, to
include a copy of the charter as an appendix to the company's proxy
or information statement at least once every three years (see
Section III.C below);
require that companies whose securities are quoted on
Nasdaq or listed on the American Stock Exchange (``AMEX'') or New
York Stock Exchange (``NYSE'') disclose in their proxy statements
certain information regarding any director on the audit committee
who is not ``independent,'' as defined in the applicable listing
standard; small business issuers would not be required to comply
with this requirement (see Section III.D below); \15\
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\15\ ``Small business issuer'' is defined in Item 10(a)(1) of
Regulation S-B, 17 CFR 228.10(a)(1), as a company with less than $25
million in revenues and market capitalization.
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require that all other companies, including small
business issuers, disclose in their proxy statements whether, if
they have an audit committee, the members are ``independent'' within
the definition of the National Association of Securities Dealer's
(``NASD''), AMEX's or NYSE's proposed amendments to their listing
standards \16\ and which definition of independence was used (see
Section III.D below); and
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\16\ The listing standards of the NASD, AMEX and NYSE are
available on their websites at: http://www.nasd.com, http://
www.amex.com, and http://www.nyse.com, respectively. See infra note
27 regarding proposed changes to their listing standards.
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create ``safe harbors'' for the information required to
be disclosed under the proposals to protect companies and their
directors from certain liabilities under the federal securities laws
(see Section III.E below).
II. Background
Accurate and reliable financial reporting lies at the heart of our
disclosure-based system for securities regulation, and is critical to
the integrity of the U.S. securities markets. Investors need accurate
and reliable financial information to make informed investment
decisions. As an increasing number of investors enter our markets, it
is important for us to continue our efforts to promote the highest
quality financial reporting. Investor confidence in the reliability of
corporate financial information is fundamental to maintaining the
liquidity and vibrancy of our markets.
Over the past few years, we have seen dramatic changes in the way
investors receive information and the speed with which information can
be and is disseminated to the market. Market demand for information
appears to be at an all time high as technology makes information
available to more people more quickly. These developments have
presented companies with an increasingly complex set of challenges. One
such challenge is that companies are under increasing pressure to meet
earnings expectations.\17\
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\17\ See, e.g., Carol J. Loomis et al., Lies, Damned Lies, and
Managed Earnings, Fortune, Aug. 2, 1999, at 74; Thor Valdmanis,
Accounting Abracadabra, USA Today, Aug. 11, 1998, at 1B; Bernard
Condon, Pick a Number, Any Number, Forbes, Mar. 23, 1998, at 124;
Justin Fox & Rajiv Rao, Learn to Play the Earnings Game, Fortune,
Mar. 31, 1997, at 76.
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Unfortunately, we have begun to see cases in which companies have
engaged in inappropriate ``earnings management,'' \18\ the practice of
distorting the true financial performance of the company. Distortions
may result from inappropriate earnings management and may undermine the
integrity of financial reporting. As Chairman Levitt has stated, when
inappropriate earnings management occurs, ``[i]ntegrity may be losing
out to illusion.'' \19\
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\18\ See, e.g., In the Matter of Livent, Inc., Exchange Act
Release No. 40937 (Jan. 13, 1999) [68 SEC Docket 2881]; see also SEC
v. W.R. Grace & Co., Litigation Release No. 16008 (Dec. 22, 1998)
[68 SEC Docket 2580].
\19\ Arthur Levitt, Chairman, SEC, Address to the NYU Center for
Law and Business (Sept. 28, 1998).
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As a result of the changes in our markets and the increasing
demands on companies, our continuing efforts to maintain the integrity
of financial reporting have gained a sense of urgency. Market changes
have highlighted the importance of strong and effective audit
committees. Effective oversight of the financial reporting process is
fundamental to preserving the integrity of our markets. Audit
committees can, and should, be the corporate participant best able to
perform that oversight function.
Audit committees oversee and monitor management and the independent
auditors in the financial reporting process, and thereby play a
critical role in assuring the credibility of financial reporting. Audit
committees can facilitate communications between a company's board of
directors, its management, and its internal and independent auditors on
significant accounting issues and policies. They can provide a forum
separate from management in which auditors can candidly discuss any
concerns. By effectively carrying out their many functions and
responsibilities, audit committees help to enhance the reliability and
credibility of financial reports.
Since the early 1940s,\20\ the Commission, along with the auditing
[[Page 55650]]
and corporate communities, has had a continuing interest in promoting
effective and independent audit committees. It was, in large measure,
with the Commission's encouragement, for instance, that the self-
regulatory organizations first adopted audit committee requirements in
the 1970s. In 1974 and 1978, the Commission adopted rules requiring
certain disclosures about audit committees.\21\ In 1980, the Commission
issued a staff report on corporate accountability that addresses some
of the issues underlying today's proposals.\22\ Former SEC Commissioner
James Treadway led the National Commission on Fraudulent Financial
Reporting that issued recommendations on corporate audit committees in
1987.\23\
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\20\ In 1940, the Commission investigated the auditing practices
of McKesson & Robbins, Inc., and the Commission's ensuing report
prompted action on auditing procedures by the auditing community. In
the Matter of McKesson & Robbins, Accounting Series Release
(``ASR'') No. 19, Exchange Act Release No. 2707 (Dec. 5, 1940).
\21\ ASR No. 165 (Dec. 20, 1974) [40 FR 1010] (requiring
disclosure of the existence and composition of the audit committee);
Exchange Act Release No. 15384 (Dec. 6, 1978) [43 FR 58522]
(requiring disclosure of the functions performed and number of
meetings held by the audit committee).
\22\ See Staff of the SEC, Division of Corporation Finance,
Report on Corporate Accountability, A Re-examination of Rules
Relating to Shareholder Communications, Shareholder Participation in
the Corporate Electoral Process and Corporate Governance Generally,
486-510 (Sept. 4, 1980).
\23\ See Report of the National Commission on Fraudulent
Financial Reporting (Oct. 1987) (the ``Treadway Report'').
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Most recently, the NYSE and NASD sponsored the Blue Ribbon
Committee in response to ``an increasing sense of urgency surrounding
the need for responsible financial reporting given the market's
increasing focus on corporate earnings and a long and powerful bull
market.'' \24\ Representatives from corporations, the accounting
profession, and the self-regulatory organizations, among others, were
members of the Blue Ribbon Committee. In February 1999, the Blue Ribbon
Committee issued ten recommendations. Several of the recommendations
call for action by the Commission, and the proposals in this release
are based in large measure on those recommendations.
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\24\ Blue Ribbon Report, supra note 7, at 17.
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The proposals in this release affirm what have long been considered
sound practice and good policy within the accounting and corporate
communities.\25\ While recognizing that the audit committee's role is
``clearly one of oversight and monitoring,'' the Blue Ribbon Committee
explains its recommendations as helping to ensure that:
\25\ See Advisory Panel on Auditor Independence (``Kirk
Panel''), Strengthening the Professionalism of the Independent
Auditor, Report by the Oversight Board of the SEC Practice Section,
American Institute of Certified Public Accountants (``AICPA'')
(Sept. 13, 1994) (the ``Kirk Panel Report''); see also the Treadway
Report, supra note 23.
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[a] proper and well-functioning system exists * * * [whereby]
the three main groups responsible for financial reporting--the full
board including the audit committee, financial management including
the internal auditors, and the outside auditors--form a ``three-
legged stool'' that supports responsible financial disclosure and
active and participatory oversight.\26\
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\26\ Blue Ribbon Report, supra note 7, at 7. As noted, the Blue
Ribbon Committee indicated that the audit committee, management, and
the independent auditors form a ``three-legged stool'' that supports
responsible financial disclosure and active and participatory
oversight. If we adopt the proposed requirement for an audit
committee report, shareholders annually will receive reports from
two of the groups--the audit committee and the independent
auditors--that describe their roles in the financial reporting
process. Some have recommended that the SEC require a report signed
by the chief executive officer or others that acknowledges
management's responsibilities for the financial statements and
internal controls. See Treadway Report, supra note 23, at 44. To
date, the Commission has encouraged the use of management reports,
but not required them. The Commission staff is considering whether
requiring management reports, so that investors will have a report
from each of the three main groups responsible for financial
reporting, would be useful to investors and serve the public
interest. If we decide to pursue mandatory management reports, a
separate proposing release will be published for public comment.
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We recognize that how audit committees function may vary from
company to company, and companies need flexibility to determine all of
the specific duties and functions of their audit committees. In that
regard, our proposals do not tell audit committees what specific duties
they must carry out or how to function. In addition, we are not
regulating the substance of the discussions between the audit committee
and management or the independent auditors, and, in fact, we are not
requiring disclosure of the substance of the discussions.
We recognize that many in the corporate community are concerned
that increased disclosure about audit committees may expose audit
committee members to additional liability, may make it more difficult
for companies to find good people willing to serve on audit committees,
and may impose added costs on companies. To address those concerns,
some of our proposals differ from the Blue Ribbon Committee's
recommendations. The differences are noted below in the specific
discussions of each proposal. In addition, proposed safe harbors that
address the liability concerns are discussed below in Section III.E.
The Blue Ribbon Committee also made recommendations that call for
action by the NASD, the NYSE, or the AICPA. In response, the NASD and
NYSE filed with the Commission proposed rule changes to their listing
standards.\27\ The significant amendments proposed by the NASD, NYSE,
and AMEX are:
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\27\ See Proposed Rule Change, NASD, File No. SR-NASD-99-48;
Proposed Rule Change, NYSE, File No. SR-NYSE-99-39. While the Blue
Ribbon Committee's recommendations were directed to the NYSE and the
NASD, the AMEX has filed proposed rule changes to its listing
standards in accordance with the recommendations. See Proposed Rule
Change, AMEX, File No. SR-AMEX-99-38. The AMEX's proposed changes
parallel the changes proposed by the NASD. It is possible that in
the future other exchanges will propose to amend their listing
standards in accordance with the Blue Ribbon Committee's
recommendations. At such time, the Commission will evaluate whether
the proposals in this release, if adopted, should be modified with
respect to new listing standards.
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a more demanding definition of ``independence'' for
audit committee members;
a requirement that audit committees include at least
three members, comprised solely of ``independent'' directors who are
financially literate,\28\ with limited exceptions (under the NASD's
and AMEX's proposed amendments to their listing standards, small
business issuers must establish and maintain an audit committee
composed of at least two members; a majority of the members must be
independent directors);
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\28\ Under proposed amendments to Section 303.01(B)(2)(b) of the
NYSE's listing standards, the board of directors would determine
what ``financially literate'' means. Under proposed amendments to
Rule 4310(c)(26)(B)(i) of the NASD's listing standards and Section
121B(b)(i) of the AMEX's listing standards, the audit committee
members must be able to read and understand fundamental financial
statements, including a company's balance sheet, income statement,
and cash flow statement.
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a requirement that at least one member of the audit
committee has accounting or related financial management expertise;
and
a requirement that companies adopt a written audit
committee charter that outlines certain specified responsibilities
of the audit committee.
Other recommendations are directed at the AICPA. The Blue Ribbon
Committee recommends that generally accepted auditing standards be
amended to require that a company's independent auditors discuss with
the audit committee the auditors' judgments about the quality, and not
just the acceptability under generally accepted accounting principles
(``GAAP''), of the company's accounting principles as applied in the
company's financial statements. Similarly, the Blue Ribbon Committee
recommends that Statement on Auditing Standards (``SAS'') No. 71\29\ be
modified to require that the independent auditors discuss with the
audit committee, or at least its chairman, and a representative of
financial management, the matters
[[Page 55651]]
described in SAS 61\30\ prior to the company filing its Quarterly
Report on Form 10-Q or 10-QSB (and preferably prior to any public
announcement of financial results), including significant adjustments
and accounting estimates, significant new accounting policies and
disagreements with management.
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\29\ See Codification of Statements on Auditing Standards, AU
Sec. 722 (``SAS 71''). SAS 71 provides guidance to independent
accountants on performing reviews of interim financial information.
\30\ SAS 61 requires independent auditors to communicate certain
matters related to the conduct of an audit to those who have
responsibility for oversight of the financial reporting process,
specifically the audit committee. Among the matters to be
communicated to the audit committee are: (1) methods used to account
for significant unusual transactions; (2) the effect of significant
accounting policies in controversial or emerging areas for which
there is a lack of authoritative guidance or consensus; (3) the
process used by management in formulating particularly sensitive
accounting estimates and the basis for the auditor's conclusions
regarding the reasonableness of those estimates; and (4)
disagreements with management over the application of accounting
principles, the basis for management's accounting estimates, and the
disclosures in the financial statements.
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III. The Proposals
A. Pre-Filing Review of Quarterly Financial Statements
Under current Commission rules, a company's interim financial
statements contained in its Quarterly Reports on Form 10-Q or 10-QSB
need not be reviewed or audited by independent auditors prior to the
company filing such forms with the Commission.\31\ We propose to amend
Rule 10-01(d) of Regulation S-X and Item 310(b) of Regulation S-B to
require that a company's interim financial statements be reviewed by an
independent public accountant prior to the company filing its Form 10-Q
or 10-QSB with the Commission. The amendments would require that
independent auditors follow ``professional standards and procedures for
conducting such reviews, as established by generally accepted auditing
standards, as may be modified or supplemented by the Commission.''
Under current auditing standards, this means that the auditors would be
required to follow the procedures set forth in SAS 71, or such other
auditing standards that may in time modify, supplement, or replace SAS
71. Consistent with current rules, we are not proposing to require that
interim financial statements be audited.\32\
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\31\ Rule 10-01(d) of Regulation S-X and Item 310(b) of
Regulation S-B, 17 CFR 210.10-01(d) and 17 CFR 228.310(b). Under
Item 302(a) of Regulation S-K, however, larger, more widely-when
necessary, reconciles amounts previously reported in a Form 10-Q or
Form 10-QSB. See 27 CFR 229.302(a).
\32\ A review of interim financial information under SAS 71
generally is limited to inquiries and analytical procedures
concerning significant accounting matters, and does not include
search and verification procedures. The objective of a review of
interim financial information differs significantly from the
objective of an audit of financial statements in accordance with
generally accepted auditing standards. The objective of a review of
interim financial information is to provide the accountant with a
basis for reporting whether material modifications should be made
for such information to conform with GAAP. The objective of an audit
is to provide a reasonable basis for expressing an opinion regarding
the financial statements taken as a whole. A review may bring to the
accountant's attention significant matters affecting the interim
financial information, but it does not provide assurance that the
accountant will become aware of all significant matters would be
disclosed in an audit. See SAS 71, para. 9 (``Objective of a Review
of Interim Financial Information'').
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Under current Commission rules, if a company discloses in its
filings with the Commission that an independent auditor has performed a
review of interim financial statements, it must file a copy of the
auditor's report.\33\ We are not proposing to modify that
requirement.\34\ Investors and other users of financial statements rely
on, and react quickly to, quarterly results. Quarterly financial
reporting, however, has never been subject to the same discipline that
is applied to annual financial reporting. Interim financial results are
not required to be audited or reviewed by an independent auditor. It is
commonplace, however, for financial analysts to set quarterly earnings
expectations for companies that they follow.\35\ The consequence of a
company failing to meet or exceed these expectations may, in some
cases, result in a precipitous decline in its stock price. As a result,
companies may be experiencing increasing pressure to ``manage'' interim
financial results. Accordingly, inappropriate earnings management could
be deterred by imposing more discipline on the process of preparing
interim financial information before filing such information with the
Commission.\36\
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\33\ Rule 10-01(d) of Regulation S-X, 17 CFR 210.10-01(d).
\34\ A conforming change to Item 310 of Regulation S-B, 17 CFR
228.310, is being proposed to require the filing of the report if
the small business issuer discloses in its filings with the
Commission that an independent accountant has performed a review of
interim financial statements
\35\ The importance of analysts to the proper functioning of our
capital markets is well-recognized. See, e.g., Dirks v. SEC, 43 U.S.
646, 656 (1983). We do not intend to cast doubt on the importance of
that role or the appropriateness of quarterly earnings estimates
\36\ In 1989, the Commission issued a concept release on whether
it should propose amendments to its rules to require more
involvement of the independent accountant in the preparation of
interim financial information. See Exchange Act Release No. 26949
(June 20, 1989) [54 FR 27023]. The Treadway Commission recommended
that the SEC require independent public accountants to review
quarterly financial data before a company releases it to the public.
Treadway Report, supra note 23, at 53.
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The reviews required by our proposal should facilitate early
identification and resolution of material accounting and reporting
issues because the auditors will be involved earlier in the year. This
is particularly important because interim financial information
generally may include more estimates than annual financial
statements.\37\ Early involvement of the auditors should reduce the
likelihood of restatements or other year-end adjustments.
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\37\ See Accounting Principles Board Opinion No. 28.
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We understand that the five largest U.S. accounting firms and
others have each recently adopted policies to require that their
clients have reviews of quarterly financial statements as a condition
to acceptance of the audit.\38\ Consequently, those firms already have
implemented our proposed requirement for the companies that are audited
by those firms.
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\38\ One firm's policy apparently applies only to clients filing
selected quarterly financial data under Item 302(a) of Regulation S-
K, 17 CFR 229.302(a).
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We request comment on the need for independent auditors to review
interim financial statements before they are filed with the Commission.
Will interim reviews result in more reliable and credible interim
financial statements? Will the involvement of independent auditors at
quarterly intervals result in fewer restatements of Forms 10-Q and 10-
QSB as a result of a year-end audit? What other benefits will be
achieved? What will be the additional cost to registrants if the
Commission requires interim reviews? Will having the auditors perform
quarterly reviews shift some of the work away from the year-end audit,
and therefore, result in lower year-end audit fees? What other ways can
we enhance the quality and reliability of interim reporting?
We request comment on whether any modifications to SAS 71 are
needed. For example, is there some formulation that would provide
flexibility yet ensure that interim reviews meet objective minimum
standards? In light of the proposed changes, are any modifications to
Item 302(a) of Regulation S-K needed? For example, should we amend Item
302(a) to require all public companies to provide supplemental
financial information? \39\
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\39\ Subjecting additional companies to the requirements of Item
302(a) would result in auditor review of their quarterly financial
information, but the review would not necessarily have to occur on a
timely basis.
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We also request your comments on the scope of the proposed
requirement. Should the requirement apply to all public companies or
only certain size public companies? If only certain size companies,
what size and why? Should the requirement apply not only to
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interim financial statements contained in quarterly reports, but those
contained in registration statements under the Securities Act of 1933
(``Securities Act'') and Exchange Act as well? Should we require that
interim reviews be completed prior to quarterly ``earnings releases,''
when a company releases to the public financial results before the Form
10-Q or 10-QSB is filed?
The Commission recently proposed a requirement providing for the
filing of quarterly financial results on Form 8-K if released prior to
the deadline for filing the Quarterly Report on Form 10-Q or 10-
QSB.\40\ We also solicited comment on whether to shorten the filing
deadline for Form 10-Q and 10-QSB. If we adopt those changes, how would
that affect your overall view of these proposals?
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\40\ See Exchange Act Release No. 40632A (Nov. 13, 1998) [63FR
67174] (the ``Securities Act Reform Release''), at Section XI.B, in
which we solicited comment on whether to shorter the filing deadline
for quarterly reports to within 30 days after the first three fiscal
quarters.
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Should we require that a report on the independent auditors' review
be filed? \41\ If so, what liability should attach to the report? \42\
Should the report clearly set forth the scope of the review procedures
and degree of reliance that can be placed on the report? Would the
inclusion of a report benefit investors?
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\41\ SAS 71 provides guidelines for the preparation of a report.
\42\ See, e.g., Rule 436 of Regulation C of the Securities Act,
17 CFR 230.436. Rule 436 provides that a report on unaudited interim
financial information shall not be construed to be a part of a
registration statement prepared or certified by an accountant within
the meaning of Sections 7 and 11 of the Securities Act.
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We request your comments on whether we should require companies to
disclose whether the quarterly financial statements have been reviewed
by independent auditors. The Blue Ribbon Committee recommends that SAS
71 be amended to require that audit committees discuss with the
auditors the matters covered in SAS 61, including significant
adjustments, management judgments and accounting estimates, significant
new accounting policies and disagreements with management, prior to the
filing of the Form 10-Q.\43\ If SAS 71 is not amended as recommended by
the Blue Ribbon Committee, should the Commission consider any other
changes to its rules, such as to require disclosure about particular
discussions between the audit committee and the auditors prior the
company filing its Form 10-Q or 10-QSB? Should we continue to permit
companies to decide whether to disclose that the independent auditors
have performed the review but eliminate the requirement to file the
review report if such disclosure is made?
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\43\ Blue Ribbon Report, supra note 7, at 36.
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B. The Audit Committee Report
Proposed new Item 306 of Regulations S-K and S-B and Item 7(e)(3)
of Schedule 14A would require that the audit committee provide a report
in the company's proxy statement (or information statement) disclosing
whether the audit committee has reviewed and discussed the audited
financial statements with management and discussed certain matters with
the independent auditors.\44\ Specifically, under paragraphs (a)(1),
(a)(2), and (a)(3) of proposed Item 306 (paragraph (a)(4) is discussed
separately, below), audit committees would be required to state
whether:
\44\ At least in some measure, these discussions are already
prescribed by the auditing literature. See SAS 61.
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(1) The audit committee has reviewed and discussed the audited
financial statements with management;
(2) The audit committee has discussed with the independent
auditors the matters required to be discussed by SAS 61, as may be
modified or supplemented; \45\ and
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\45\ See ASB Exposure Draft, supra note 13.
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(3) The audit committee has received the written disclosures and
the letter from the independent auditors required by ISB Standard
No. 1, as may be modified or supplemented, and has discussed with
the auditors the auditors' independence.
If the company does not have an audit committee, the board committee
tasked with similar responsibilities, or the full board of directors,
would be responsible for the disclosure.
Proposed paragraphs (a)(1), (2), and (3) of Item 306 would require
audit committees to disclose whether the review and discussions took
place and whether the letter and disclosures were received. The
proposals would not require audit committees to perform the review and
have the discussions. The proposed amendments would not require audit
committees to take specific actions or adopt specific procedures. We
are not proposing to require disclosure of the details of deliberations
between or among the audit committee members, independent auditors, and
management.\46\
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\46\ The proposals, of course, are not intended to either
diminish or enhance a company's current disclosure obligations under
the proxy rules.
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The required disclosure will help inform shareholders of the audit
committee's oversight with respect to financial reporting, and
underscore the importance of the audit committee's participation in the
financial reporting process. The proposed language of paragraphs (a)(1)
and (a)(2) is similar to the language recommended by the Blue Ribbon
Committee. Moreover, the language is consistent with the Blue Ribbon
Committee's recommendation to the AICPA that it amend SAS 61.\47\
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\47\ Blue Ribbon Report, supra note 7, at 33.
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The disclosure required by paragraph (a)(3) relates to written
disclosures, a letter from the independent auditors, and discussions
between the audit committee and the independent auditors required by
ISB Standard No. 1. The Commission has long recognized the importance
of auditors being independent from their audit clients.\48\ Public
confidence in the reliability of a company's financial statements
depends on investors perceiving the company's auditors as maintaining
integrity and objectivity, being without conflicting interests with
audit clients, and exercising independent judgment. Accordingly, we
think that investors will benefit from the proposed disclosures.
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\48\ The federal securities laws recognize the importance of
independent auditors. See, e.g., Items 25 and 26 of Schedule A of
the Securities Act and Sections 12(b)(1)(J) and 13(a)(2) of the
Exchange Act, 15 U.S.C. Secs. 78l(b)(1)(J) and 78m(a)(2).
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Paragraph (a)(4) of the proposed rule would require the audit
committee to state in the audit committee's report to be included in
the company's proxy statement whether, based on the review and
discussions described in paragraphs (a)(1) through (a)(3), anything
came to the attention of the members of the audit committee that caused
the audit committee to believe that the audited financial statements
included in the company's Annual Report on Form 10-K or 10-KSB, as
applicable, for the year then ended contain an untrue statement of
material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which they were
made, not misleading. We believe that this proposed amendment would
reinforce the audit committee's awareness and acceptance of its
responsibilities, and make visible for investors the audit committee's
role in promoting reliable and transparent financial reporting.
The proposed language of paragraph (a)(4) differs from the Blue
Ribbon Committee's recommendation.\49\ Concerns have been expressed
that the language in the Blue Ribbon Committee's recommendation is a
[[Page 55653]]
GAAP ``certification'' that implicitly would require that the audit
committee know all of the nuances of GAAP. We have modified the Blue
Ribbon Committee's language to address that concern. In performing its
oversight function, the audit committee likely will be relying on
advice and information that it receives in its discussions with
management and the independent auditors. Accordingly, the proposed
language acknowledges that the audit committee will be forming its
belief based on the discussions with management and the auditors, but
also focuses members of the audit committee on their role in the
financial reporting process. The statement that ``nothing came to the
attention of the audit committee members,'' when combined with the need
for a sound internal reporting system, discussed below, is intended to
encourage audit committees to ``ask tough questions of management and
outside auditors'' \50\ to serve the interests of investors.
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\49\ The Blue Ribbon Committee's recommendation is for the audit
committee to state that, in reliance on the review and discussions
with management and the auditors, the audit committee ``believes
that the company's financial statements are fairly presented in
conformity with Generally Accepted Accounting Principles (GAAP) is
all material respects.'' Blue Ribbon Report, supra note 19.
\50\ See supra note 19.
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This approach is consistent with state corporation law that permits
board members to rely on the representations of management and the
opinions of experts retained by the corporation.\51\ The Blue Ribbon
Committee noted the ``impracticability of having the audit committee do
more than rely upon the information it receives, questions, and
assesses in making this disclosure.'' \52\
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\51\ Delaware General Corporation Law, for example, states that
board members are ``fully protected in relying in good faith upon
the records of the corporation and upon such information, opinions,
reports or statements presented to the corporation by any of the
corporation's officers or employees . . . or by any other person as
to matters the member reasonably believes are within such other
person's professional or expert competence. * * *'' Del. Code Ann.
tit. 8, 141(e).
\52\ See Blue Ribbon Report, supra note 7, at 34; see also id.
at 7 (``The [audit] committee's job is clearly one of oversight and
monitoring, and in carrying out this job it acts in reliance on
senior financial management and the outside auditors.'').
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Some have expressed concerns that requiring a report from the audit
committee will result in increased exposure to liability for the audit
committee members. We do not believe that improved disclosure about the
audit committee and increased involvement by the audit committee should
result in increased exposure to liability. Under state corporation law,
the more informed the audit committee becomes through its discussions
with management and the auditors, the more likely that the ``business
judgment rule'' will apply and provide broad protection.\53\
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\53\ See 1 American Law Institute, Principles of Corporate
Governance: Analysis and Recommendations 134-98 (1994); In re
Caremark Int'l Inc. Derivative Litig., 698 A.2d 959, 967-70 (Del.
Ch. 1996).
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Under both state corporation law and the federal securities laws,
if the audit committee's discussions with management and the
independent auditors become part of the financial reporting process and
are used to form a belief about the financial statements, the
likelihood increases substantially that the audit committee's decisions
about the financial statements and other matters will be protected.\54\
Those discussions should serve to strengthen the ``information and
reporting system'' that should be in place.\55\ Adherence to a sound
process should result in less, not more, exposure to liability.\56\
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\54\ We note that under Section 11 of the Securities Act, 15
U.S.C. Sec. 77k, Section 10(b) of the Exchange Act, 15 U.S.C.
Sec. 78j(b), and other provisions of the federal securities laws,
the members of an audit committee may have additional
responsibilities, beyond the statement contemplated in subparagraph
(a)(4), with respect to material misstatements and omissions. The
Commission previously has stated that if ``an officer or director
knows or should know that his or her company's statements concerning
particular issues are inadequate or incomplete, he or she has an
obligation to correct that failure.'' Report of Investigation
Pursuant to Section 21(a) of the Exchange Act Concerning the Conduct
of Certain Former Officers and Directors of W.R. Grace & Co.,
Exchange Act Release No. 39157 (Sept. 30, 1997) [65 SEC Docket
1581].
\55\ Caremark, 698A.2d at 970 (boards must assure ``themselves
that information and reporting systems exist in the organization
that are reasonably designed to provide to senior management and to
the board itself timely, accurate information sufficient to allow
management and the board, each within its scope, to reach informed
judgments concerning both the corporation's compliance with law and
its business performance'').
\56\ See generally Report of the Public Oversight Board
(``POB''), ``Directors, Management, and Auditors: Allies in
Protecting Shareholder Interests,'' in which the POB discusses,
among other things, a recommendation of the Kirk Panel to require
audit committees to discuss with management and the auditors the
quality of the accounting principles and judgments used in preparing
financial statements. The POB notes its belief that compliance with
that recommendation would not increase the exposure of board members
to litigation because, among other things, the procedures will
reduce the possibility that the financial statements are in fact
misleading, thereby reducing the danger of finding directors at
fault, and the additional steps taken should be persuasive in
convincing courts and juries that the financial statements were
prepared with care.
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Finally, we believe that the proposed requirement of paragraph
(a)(4) is consistent with our view that by signing documents filed with
the Commission, board members implicitly indicate that they believe
that the filing is accurate and complete. In this regard, we believe
that the proposed rule is consistent with current rules requiring board
members to sign the company's Annual Report on Form 10-K or 10-KS \57\
and our recent proposals to amend the signature sections of Exchange
Act and Securities Act reports.\58\ As the Commission recently stated:
``When the public sees a corporate official's signature on a document,
it understands that the official is thereby stating that he believes
that the statements in the document are true.'' \59\
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\57\ The signature requirement is described in General
instruction D of Form 10-K and General Instruction C of Form 10-KSB.
The Commission amended the signature requirements for Form 10-K in
1980 in order to ``enhance director awareness of and participation
in the preparation of the Form 10-K information.'' See Securities
Act Release No. 6176 (Jan. 15, 1980) [45 FR 5972].
\58\ Securities Act Reform Release, supra note 40, at Section
XI.C.
\59\ Brief for Securities and Exchange Commission, Amicus
Curiae, at 7, Howard v. Everex Systems, Inc. (9th Cir. 1999) (No.
98-17324) (citing cases).
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Proposed paragraph (b) of Item 306 would require that the new
disclosure appear over the printed names of each member of the audit
committee.\60\ The requirement should help to emphasize the importance
of the audit committee's role to shareholders. We do not propose to
require that audit committee members provide individual signatures.
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\60\ This approach is consistent with the current treatment of
the report from the company's compensation committee. See
Instruction 9 to Item 402(a)(3) of Regulation S-K, 17 CFR 229.402.
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We request your comments on whether the proposed disclosure would
provide useful information to shareholders, and would reinforce the
audit committee's awareness and acceptance of its responsibilities.
While the amendments are not designed to elicit disclosure about the
substance of the audit committee's deliberations, would they
nonetheless result in meaningful disclosure? Should we instead require
more complete disclosure about the activities, processes and/or
discussions of the audit committee, such as by requiring the committee
to identify the significant accounting issues it considered and/or
discussed with management and the independent auditors and the
conclusions reached about those issues? Should we require further
disclosures about the basis for the audit committee's belief about the
financial statements?
Would the proposed rule's purposes be served if we required less
disclosure about the audit committee than proposed? Are all of the
requirements necessary? For example, should we merely supplement Item
7(e) to require the company to disclose more generally whether the
audit committee has met with management and the independent auditors to
discuss significant accounting issues that developed in preparing the
financial statements? Is the disclosure about discussions with
management sufficient? For example, the Blue Ribbon Committee
[[Page 55654]]
recommends that the audit committee be required to state whether they
discussed with management certain of the accounting matters that the
audit committee must discuss with the auditors under SAS 61. Should we
require that disclosure?
We request comment on alternative formulations of paragraph (a)(4)
of proposed Item 306. We are considering an alternative formulation,
for example, that would require the audit committee to state whether,
based on the review and discussions with management and auditors, the
audit committee is aware of any material modifications that should be
made to the audited financial statements, and to state whether the
audit committee recommended to the Board that the audited financial
statements be included in the company's Annual Report on Form 10-K or
10-KSB (as applicable) filed with the Commission. Another possible
formulation has been suggested by Ernst & Young.\61\ Will those
formulations achieve the intended objectives?
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\61\ See Exhibit 1 to Letter from Ernst & Young to Harvey J.
Goldschmid, General Counsel, and Lynn E. Turner, Chief Accountant,
SEC (Aug. 20, 1999). A copy of the letter has been placed in the
public file for this rulemaking.
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Should we require more disclosure about the auditors' independence?
For example, should we require disclosure about the substance of the
discussions between the audit committee and the auditors regarding the
auditors' independence?
We request your comments on whether the requirement of proposed
paragraph (b) of Item 306 would effectively encourage audit committee
members to focus on the specific disclosure obligation. Would the
purpose be served more effectively if we required individual
signatures?
We request your comments on whether the proxy statement/information
statement is the appropriate place for the proposed new disclosure. We
propose to include the disclosure in the proxy materials because we
believe that the disclosure may have a direct bearing on shareholders'
voting decisions, and because the proxy or information statement is
actually delivered to shareholders and is accessible on the SEC's web
site. In addition, we are proposing that the disclosure only be
provided in a proxy or information statement relating to an annual
meeting of shareholders at which directors are to be elected (or
special meeting or written consents in lieu of such meeting). We are
not proposing to include the new disclosure in the annual report to
shareholders \62\ because that document is not accessible
electronically on our web site, though under our rules it must be sent
to every shareholder.\63\
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\62\ See Rule 14a-3 of the Exchange Act, 17 CFR 240.14a-3.
\63\ Nothing, of course, would preclude a company from including
such disclosures in its annual report to shareholders or in any
other report.
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The Blue Ribbon Committee, however, recommends that the disclosure
be included in the company's Annual Report on Form 10-K and annual
report to shareholders. Should we instead, or additionally, include the
information in one or both of those documents? Should the disclosure be
required only when the proxy or information statement relates to an
election of directors? Should the disclosure only be required to be
provided one time during the year (e.g., in a proxy statement for an
annual meeting at which directors are to be elected, but not in proxy
solicitation material used in a subsequent election contest during that
same year)? What are the implications, if any, if the proxy statement
that includes the audit committee's report is of a later date than the
date the Form 10-K is filed? Is it feasible for audit committees'
reports to be included in proxy statements given the timing of the
distribution of proxies and the completion of audit procedures and
other events that must occur before the audit committee report may be
finalized?
There may be companies, such as companies registered under section
15(d) \64\ of the Exchange Act, that are not required to prepare proxy
statements. Should we require those companies to provide the
disclosures in another filing, such as in the Form 10-K or 10-KSB?
Would we need to provide a safe harbor for the disclosures by those
companies? If we do not make the requirement applicable to Section
15(d) companies, should we keep the text of the new requirement in
Regulation S-K or, for example, move it into Item 7 of Schedule 14A?
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\64\ 15 U.S.C. Sec. 78o(d).
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C. Audit Committee Charters
We are proposing to require companies to disclose in their proxy
statements or information statements whether their audit committee is
governed by a charter. In addition, if the audit committee has a
charter, a copy of the charter would have to be included as an appendix
to the proxy or information statement at least once every three years.
The new requirement would appear in new paragraph (e)(3) under Item 7
of Schedule 14A.
The new disclosure should help shareholders assess the role and
responsibilities of the audit committee, and help focus committee
members on their responsibilities as expressed in the charter. We
believe that audit committees that have their responsibilities set
forth in written charters are more likely to play an effective role in
overseeing the company's financial reports.
The Blue Ribbon Committee recommends that the audit committee state
whether it has satisfied its responsibilities during the prior year in
compliance with its charter. We are concerned that requiring a
statement about compliance with the charter may have the undesired
effect of encouraging skimpy, broadly-worded and vague committee
charters to minimize the audit committee members' exposure to
liability. Accordingly, we are not proposing to require any statements
about whether the audit committee has complied with the charter. The
proposed amendments would not require companies to adopt audit
committee charters, or dictate the content of the charter if one is
adopted.\65\
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\65\ We note, however, that, in response to the Blue Ribbon
Committee recommendations, the NYSE, NASD, and AMEX have proposed to
require the audit committee to: (1) Adopt a formal written charter
that is approved by the full board of directors and that specifies
the scope of the committee's responsibilities, and how it carries
out those responsibilities, including structure, processes, and
membership requirements; and (2) review and reassess the adequacy of
the audit committee's charter on an annual basis.
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Should we require companies to disclose whether they have adopted
an audit committee charter, but not require that the charter be
attached as an appendix to the proxy statement? In that case, we ask
you to consider whether we should require a plain English summary of
the charter's material terms, rather than a copy of the entire charter.
Would such a disclosure requirement result in boilerplate disclosures?
Is the charter itself useful information for investors?
Should we require the audit committee to disclose whether it has
complied with its charter, as recommended by the Blue Ribbon Committee?
We could require, for example, that the audit committee state whether
it has complied in all material respects with the charter. Would a
materiality threshold be appropriate, or some other threshold, such as
compliance in all significant or substantive respects? We request your
comments on whether we should instead require disclosure about any
material deviations by the audit committee from their charter
[[Page 55655]]
obligations. We request your comments on whether a requirement to
disclose compliance with an audit committee charter will have the
undesired effect of encouraging skimpy, broadly-worded and vague
committee charters. If any such disclosure is required, would we need
to provide a safe harbor from liability for that disclosure? If so,
what kind of safe harbor is needed?
Is requiring that the charter be attached as an appendix every
three years the appropriate time frame? Should we require that it be
attached as an appendix more frequently or less frequently? \66\ Should
we require that the charter also be attached as an appendix when there
has been a material or substantive--or any--change in the charter?
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\66\ For example, only certain documents on file with the
Commission may be incorporated by reference for more than five
years. See General Instruction (a) to Regulation S-K, 17 CFR
229.10(a).
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Should we require reporting companies whose securities are not
listed on the NYSE or AMEX or quoted on Nasdaq to disclose whether they
have a charter? If these companies do not have a charter, should we
require disclosure of the operative document of the audit committee
(articles of incorporation, by-laws, etc.) or the material terms of the
document? If so, should those documents be filed once every three years
or some other interval? If a company does not have a charter or similar
document, should we require disclosure of that fact?
Finally, we seek comments on whether the disclosure is properly
included in the proxy or information statement, as proposed, or whether
the disclosure should be included alternatively, or additionally, in
another document, such as the annual report to shareholders, or the
Annual Report on Form 10-K or 10-KSB.
D. Disclosure About ``Independence'' of Audit Committee Members
As early as 1940, the Commission encouraged the use of audit
committees composed of independent directors.\67\ As the Commission
staff stated in a report to Congress in 1978, ``[i]f the [audit]
committee has members with vested interests related to those of
management, the audit committee probably cannot function effectively.
In some instances this may be worse than having no audit committee at
all by creating the appearance of an effective body while lacking the
substance.'' \68\ Further, as the Blue Ribbon Committee noted, `` * * *
common sense dictates that a director without any financial, family, or
other material personal ties to management is more likely to be able to
evaluate objectively the propriety of management's accounting, internal
control and reporting practices.'' \69\
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\67\ See supra note 20.
\68\ Staff of the SEC, 95th Cong., 2d Sess., Report to Congress
on the Accounting Profession and the Commission's Oversight Role,
Subcommittee on Governmental Efficiency and the District of Columbia
of the Senate Committee on Governmental Affairs, at 97 (Comm. Print
July 1978).
\69\ Blue Ribbon Report, supra note 7, at 22.
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In response to the Blue Ribbon Committee's recommendations, the
NYSE, AMEX, and NASD have proposed amendments to their respective
listing standards regarding, among other things, the ``independence''
of all audit committee members. The NYSE's, AMEX's, and NASD's proposed
rule changes would provide a narrowly tailored exception to a
requirement that all members of the audit committee be independent.
Specifically, the NYSE, AMEX, and NASD have proposed that, under
exceptional and limited circumstances, one director who is not
independent may be appointed to the audit committee if the Board
determines that membership on the committee by the individual is
required by the best interests of the corporation and its shareholders,
and the Board discloses, in the next annual proxy statement subsequent
to such determination, the nature of the relationship and the reasons
for that determination.
Because of the importance of having an audit committee that is
comprised of independent directors, we believe that shareholders should
know when a director who is not independent is a member of an audit
committee. We are proposing to require that companies whose securities
are not listed on the NYSE or AMEX or quoted on Nasdaq, including small
business issuers, disclose in their proxy statements whether, if they
have an audit committee, the members are ``independent'' within the
definition of the NYSE's, AMEX's, or NASD's proposed amendments to
their listing standards. We are also proposing rules to require that
for companies whose securities are listed on the NYSE or AMEX or quoted
on Nasdaq, if the company's board determines in accordance with the
proposed amendments to section 303.02(D) of the NYSE's listing
standards, Section 121(B)(b)(ii) of the AMEX's listing standards, or
sections 4310(c)(26)(B)(ii) or 4460(d)(2)(B) of the NASD's listing
standards, as applicable and as may be modified or supplemented, to
appoint one director to the audit committee who is not independent (as
independence is defined in sections 303.01(B) (2)(a) and (3) of the
NYSE's listing standards, Section 121(A) of AMEX's listing standards or
Section 4200(a)(15) of the NASD's listing standards, as applicable and
as may be modified or supplemented), the company must disclose the
nature of the relationship that makes that individual not independent
and the reasons for the board's determination. Small business issuers
are not required to comply with this requirement.\70\
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\70\ The NASD and AMEX excluded small business issuers from
certain of the proposed amendments to their listing standards,
including the requirement that all audit committee members be
independent.
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We request comment on whether the disclosures will help inform
investors about the independence of the audit committee. If the
proposed amendments to the NYSE's, AMEX's, and NASD's listing standards
are not adopted, are there disclosures that we could require that would
achieve the same purposes? Is the proposed requirement to disclose the
nature of the relationship of the director who is not ``independent''
and the basis for the Board's determination specific enough, or will
the requirement result in boilerplate disclosure?
Companies whose securities are not listed on the NYSE or AMEX or
quoted on Nasdaq would be able to choose which definition of
``independence'' to apply to the audit committee members in making the
disclosure. Whichever definition is chosen must be applied consistently
to all members of the audit committee. Should we require small business
issuers to comply with the requirement to disclose the nature of the
relationship that makes the individual not independent? Will permitting
companies to choose which definition to apply confuse investors in
comparing companies? Should we instead mandate which definition should
be used, and if so, which definition?
E. Proposed Safe Harbors
In making these proposals, we do not intend to subject companies or
their directors to increased exposure to liability under the federal
securities laws, or to create new standards for directors to fulfill
their duties under state corporation law. We do not believe that the
disclosure requirements will result in increased exposure to liability.
To the extent the proposed disclosure requirements would result in more
clearly defined procedures for, and disclosure of, the operation of the
audit committee, liability claims alleging breach of fiduciary duties
under state law actually may be reduced.
[[Page 55656]]
We recognize that, notwithstanding the audit committee's critical
oversight role of the financial reporting process and financial
statements, management ultimately has responsibility for the company's
financial statements. As discussed above in Section III.B regarding the
audit committee's report, the proposed disclosure requirements differ
from the Blue Ribbon Committee's recommendations in response to
liability concerns. In addition, we propose to follow the Blue Ribbon
Committee's recommendation to adopt liability ``safe harbors'' to cover
the new disclosures.\71\ The ``safe harbors'' would track the treatment
of compensation committee reports under Item 402 of Regulation S-K,\72\
and would appear in proposed paragraph (c) in new Item 306 of
Regulations S-K and S-B and in proposed paragraph (e)(v) of Schedule
14A. Under the ``safe harbors,'' the additional disclosure would not be
considered ``soliciting material,'' ``filed'' with the Commission,
subject to Regulation 14A or 14C or to the liabilities of Section 18 of
the Exchange Act, except to the extent that the company specifically
requests that it be treated as soliciting material, or specifically
incorporates it by reference into a document filed under the Securities
Act or the Exchange Act.\73\
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\71\ Blue Ribbon Report, supra note 7, at 35.
\72\ See Instruction 9 to Item 402(a)(3) of Regulation S-K, 17
CFR 229.402(a)(3).
\73\ Of course, the antifraud provisions of these Acts would
continue to apply.
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We request your comments on whether we should adopt these proposed
liability ``safe harbors'' to cover the information disclosed under the
proposed amendments. Is a safe harbor necessary?
Should the safe harbors apply to all of the required disclosures or
only certain of the disclosures? Is a safe harbor needed for factual
statements? For example, is a safe harbor needed for the disclosure
regarding whether the audit committee has discussed with the auditors
the auditors' independence and received the written disclosures and
letter from the auditors when these disclosures are factual in nature?
Is the scope of the safe harbor appropriate?
IV. Request for Comments
We request your comments on the proposals, other matters that may
have an impact on the proposals, and your suggestions for additional
changes. In addition to the specific questions raised in Section III
above, we request your comment on the matters discussed below.
First, the proposals generally do not distinguish between a Fortune
500 company and a small start-up company reporting on small business
forms.\74\ We request your comment on whether the scope of one or more
of the proposed new requirements should be narrowed to exclude
companies under a certain size. If so, should we exclude companies
considered under the Commission's rules to be ``small business
issuers'' (companies that have revenues and public float of less than
$25 million)? The Commission has proposed to revise the definition of
small business issuer to include companies with less than $50 million
in annual revenues, and to delete the public float portion of the
test.\75\ If that proposal were adopted, would that affect your view on
the applicability of today's proposals to small companies? Should there
be a higher cutoff, such as $100 million or $200 million public float
and/or revenues? If there should be a different standard, should it be
based on additional or alternative criteria, such as total assets or
reporting history?
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\74\ The proposed disclosure requirements about the independence
of audit committees does, however, distinguish between companies
whose securities are listed on the NYSE or AMEX or quoted on Nasdaq
and all other companies.
\75\ See Securities Act Reform Release, supra note 40, at
Section V.E.2.
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The Blue Ribbon Committee's recommendations directed to the
Commission are silent on whether to apply the requirements to all
companies, regardless of size. In preparing your comments, you should
consider whether the proportionate cost of complying with some of the
proposals may be greater for smaller companies than for larger ones.
You should also consider, however, that one recent study found that the
incidence of financial fraud at smaller companies may be greater than
at larger companies.\76\
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\76\ See Beasley, Carcello, and Hermanson, Fraudulent Financial
Reporting: 1987-1997, An Analysis of U.S. Public Companies (Mar.
1999) (study commissioned by the Committee of Sponsoring
Organizations of the Treadway Commission) (the ``COSO Report'').
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We also request your comments on whether any or all of the
proposals should apply to investment companies registered under the
Investment Company Act of 1940. The proposals for requiring audit
committee disclosure as currently formulated would only apply to
closed-end funds. As we discussed above, our proposals are intended to
work in conjunction with the listing standards of the NYSE, AMEX, and
the NASD that would impose requirements on companies for their audit
committees. Because mutual funds are not subject to the listing
standards of an exchange or a national securities association that
require companies to have audit committees, the Commission has not
included those funds in the proposals at this time.\77\ We also request
your comments on whether interim financial statements of closed-end
funds should be reviewed by independent auditors before being sent to
shareholders.\78\
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\77\ See proposed paragraph (e)(3)(vi) of Item 7, Schedule 14A.
The proposed rules also exclude unit investment trusts (``UITs'')
from the disclosure requirements because they do not have boards of
directors and, therefore, do not have audit committees.
\78\ Because closed-end and open-end funds and UITs generally
are not required to file Form 10-Qs, these investment companies
would not be subject to the proposal requiring the review of
quarterly financial statements filed on Form 10-Q. Business
development companies, however, are required to file Form 10-Qs and
would be subject to the proposal.
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The proposals would not apply to ``foreign private issuers,'' which
are exempt from the proxy rules, and which are not required to file
Quarterly Reports on Form 10-Q or 10-QSB.\79\ We request your comments
on whether any one or more of our proposed amendments should apply to
``foreign private issuers.''
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\79\ A ``foreign private issuer'' must file reports on Form 6-K
promptly after the information required by the Form is made public
in accordance with the laws of its home country or a foreign
securities exchange. See 17 CFR 240.13a-16(b). The proposed
amendments would, however, apply to a ``foreign private issuer''
that elected to file reports under the disclosure rules for U.S.
companies.
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V. Paperwork Reduction Act
Certain provisions of the proposed amendments to Regulations 14A,
14C, S-X, S-B, and S-K contain ``collection of information''
requirements within the meaning of the Paperwork Reduction Act of 1995
(44 U.S.C. 3501 et seq.), and the Commission has submitted proposed
revisions to those rules to the Office of Management and Budget
(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR
1320.11. The titles for the collections of information are: (1) ``Proxy
Statements--Regulation 14A (Commission Rules 14a-1 through 14a-15) and
Schedule 14A;'' (2) Information Statements--Regulation 14C (Commission
Rules 14c-1 through 14c-7 and Schedule 14C); (3) Regulation S-X; (4)
Regulation S-B; and (5) Regulation S-K.\80\ An agency may not conduct
or sponsor, and a person is not required to respond to, a collection of
information unless it displays a currently valid control number.
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\80\ The Commission is not proposing any changes to Forms 10-Q
or 10-QSB.
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Schedule 14A (OMB Control No. 3235-0059) \81\ and Schedule 14C (OMB
[[Page 55657]]
Control No. 3235-0057) \82\ were adopted pursuant to Sections 14(a) and
14(c) of the Exchange Act. Schedule 14A prescribes information that a
company must include in its proxy statement to ensure that shareholders
are provided material information relating to voting decisions.
Schedule 14C prescribes information that a company must include in its
information statement under those circumstances.
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\81\ 17 CFR 240.14a-101.
\82\ 17 CFR 240.14c-101.
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The Commission currently estimates that Schedule 14A results in a
total annual compliance burden of 173,906 hours. The burden was
calculated by multiplying the estimated number of entities filing
Schedule 14A annually (approximately 9,892) by the estimated average
number of hours each entity spends completing the form (approximately
13 hours).\83\ The Commission currently estimates that Schedule 14C
results in a total annual compliance burden of 4,448 hours. The burden
was calculated by multiplying the estimated number of entities filing
Schedule 14C annually (approximately 253) by the estimated average
number of hours each entity spends completing the form (approximately
13 hours). The Commission based the number of entities that would
complete and file each of the forms on the actual number of filers
during the 1998 fiscal year. The staff estimated the average number of
hours each entity spends completing each of the forms by contacting a
number of law firms and other persons regularly involved in completing
the forms. Regulations S-X, S-K, and S-B do not impose reporting
burdens directly on public companies. For administrative convenience,
each of these regulations is currently assigned one burden hour.
Although these regulations set forth disclosure requirements, the
burden associated with the requirements is reflected in the forms and
schedules that refer to those regulations.
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\83\ Thirteen hours is 25% of the total company reporting time
(75% is shown as cost).
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We believe that the proposed amendments will bolster investor
confidence in the securities markets by informing investors about the
important role that audit committees play in the financial reporting
process and enhance the reliability and credibility of financial
statements of public companies. The proposed amendments would require
companies to include additional disclosure in Schedules 14A and 14C,
including certain information about the company's audit committee. The
audit committee would be required to disclose whether the audit
committee had certain discussions with management and the company's
auditors. The substance of the discussions would not be required to be
disclosed. The proposed amendments would also require companies that
have adopted a written charter to include a copy of the charter as an
appendix to Schedules 14A and 14C at least once every three years. The
amendments do not require a company to prepare a charter. We estimate
that, on average, the additional disclosure would require approximately
one additional burden hour per filing, whether on Schedule 14A or 14C.
Accordingly, the proposed amendments, if adopted, would result in an
aggregate of 9,892 additional burden hours for Schedule 14A annually,
and an aggregate 253 additional burden hours for Schedule 14C annually.
We request your comments on the accuracy of our estimates.
Compliance with the disclosure requirements is mandatory. There
would be no mandatory retention period for the information disclosed,
and responses to the disclosure requirements will not be kept
confidential.
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments to: (i) Evaluate whether the proposed collection of
information is necessary for the proper performance of the functions of
the agency, including whether the information will have practical
utility; (ii) evaluate the accuracy of the Commission's estimate of the
burden of the proposed collection of information; (iii) determine
whether there are ways to enhance the quality, utility, and clarity of
the information to be collected; and (iv) evaluate whether there are
ways to minimize the burden of the collection of information on those
who are to respond, including through the use of automated collection
techniques or other forms of information technology.
Persons submitting comments on the collection of information
requirements should direct the comments to the Office of Management and
Budget, Attention: Desk Officer for the Securities and Exchange
Commission, Office of Information and Regulatory Affairs, Washington,
DC 20503, and should send a copy to Jonathan G. Katz, Secretary,
Securities and Exchange Commission, 450 Fifth Street, NW., Washington,
DC 20549-0609, with reference to File No. S7-22-99. Requests for
materials submitted to OMB by the Commission with regard to these
collections of information should be in writing, refer to File No. S7-
22-99, and be submitted to the Securities and Exchange Commission,
Records Management, Office of Filings and Information Services. OMB is
required to make a decision concerning the collection of information
between 30 and 60 days after publication of this release. Consequently,
a comment to OMB is assured of having its full effect if OMB receives
it within 30 days of publication.
VI. Cost-Benefit Analysis
The proposed amendments should improve disclosure related to the
functioning of the corporate audit committees. We believe that the
proposed amendments will bolster investor confidence in the securities
markets by informing investors about the important role that audit
committees play in the financial reporting process and enhance the
reliability and credibility of financial statements of public
companies. As the Blue Ribbon Committee summarized:
Improving oversight of the financial reporting process
necessarily involves the imposition of certain burdens and costs on
public companies. Despite these costs, the Committee believes that a
more transparent and reliable financial reporting process ultimately
results in a more efficient allocation of and lower cost of capital.
To the extent that instances of outright fraud, as well as other
practices that result in lower quality financial reporting, are
reduced with improved oversight, the benefits clearly justify these
expenditures of resources.\84\
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\84\ Blue Ribbon Report, supra note 7, at 19.
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Reviews of Quarterly Financial Statements
We propose to require interim reviews of quarterly financial
statements filed on Form 10-Q or 10-QSB.\85\ Under the proposed
amendments, the company's quarterly financial statements would have to
be reviewed by independent auditors using ``professional standards and
procedures for conducting such reviews, as established by generally
accepted auditing standards, as may be modified or supplemented by the
Commission.'' Currently, that means that the review would follow the
procedures established by SAS 71. The proposed amendments apply only to
the financial information contained in the company's quarterly report
on Form 10-Q or 10-QSB. Accordingly, it would not impose any
requirements on quarterly financial information that may be released to
the public before the filing of the Form 10-Q or 10-QSB, such as the
so-called quarterly ``earnings release.''
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\85\ See Section III.A above.
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We believe that companies are under increasing pressure to meet
financial
[[Page 55658]]
analysts' expectations, and that pressure can be even more acute in the
context of reports on quarterly earnings. We believe that the
participation of auditors in the financial reporting process at interim
dates will help to counterbalance that pressure and impose increased
discipline on the process of preparing interim financial information.
Auditor involvement in the financial reporting process earlier in the
year should facilitate timely identification and resolution of
significant and sensitive issues and result in fewer year-end
adjustments, which should reduce the cost of annual audits. The
increased focus and discipline imposed on the preparation of interim
financial statements should enhance the efficiency of the capital
markets by improving the reliability of quarterly financial statements.
We do not currently have sufficient information to quantify these
or other potential benefits. We, therefore, request your comments,
including supporting data, on the degree to which the proposal is
likely to improve the reliability of interim financial reporting.
The five largest U.S. accounting firms, the so-called ``Big 5,''
and some other firms, currently have in place policies that require
that their clients have interim reviews as a condition to acceptance of
an audit. The firms' adoption of these policies, and the acceptance of
them by their clients, indicates that the value of these reviews
justifies the associated costs.
Based on the staff's review of the Compustat database containing
auditor information for about 8,600 companies for calendar year 1997,
we estimate that approximately 75% of public companies (about 6,450)
are clients of the Big 5 accounting firms, and that approximately 25%
(or 2,150) are audited by other accounting firms. We request your
comments on the accuracy of those estimates, including supporting data.
Some of those 2,150 companies are audited by firms that have quarterly
review policies similar to those of the Big 5 firms.
Based on the data provided to staff by the SEC Practice Section of
the AICPA (``SECPS''), we estimate the incremental cost to conduct a
SAS 71 review will be nominal for those companies currently audited by
the Big 5 firms and for the remaining companies would range from
approximately $1,000 to about $4,000 per quarter. The total cost of
upgrading for all companies audited by non-Big 5 accounting firms would
be approximately $16 million per year. We request your comments and
supporting empirical data on the accuracy of these estimates and
conclusions.
Firms providing information to the SECPS indicated that the
procedures they currently use are similar, if not the same, as those
described in SAS 71. Most indicated that review reports are seldom
issued. The firms also indicated that they are not aware of (and do not
expect) clients switching auditing firms because of their new policies.
The firms providing information to the SECPS identified several
benefits that they believe would result from the reviews, including
better interim reporting, earlier identification and resolution of
accounting issues, improvement in the quality of accounting estimates,
and improved communications between clients and auditors. Medium and
smaller sized accounting firms, however, indicated to the SECPS that
SAS 71 reviews of small companies' interim financial statements may
cause delays in filing Forms 10-Q or 10-QSB, be relatively more costly
for small companies, be hampered by inadequate financial reporting
processes, and would result in small companies shifting work from the
company to the CPA firm.
The firms generally indicated, however, that the costs of reviews
of quarterly financial statements vary depending on several factors,
including: (i) The sophistication of the client's accounting and
reporting system; (ii) the quality of the client's accounting
personnel; (iii) the identification of ``fraud risk factors;'' (iv) the
client's industry; (v) the number and location of the client's
subsidiaries; (vi) the seasonality of the client's business; (vii) the
existence of contentious accounting issues; and (viii) whether there
will be a staffing ``crunch'' at the firm to handle the reviews each
quarter.
Approximately half of the firms consulted believed that the cost of
the reviews would be offset, in part, by a reduction in the annual
audit fee, although the amount of the reduction in audit fees may vary
based on, among other things, the performance of substantive audit
procedures during the review, whether the review results in the client
having better internal accounting and reporting controls, and how the
results of the review impact planning for the annual audit. Because the
cost of reviews would be only partially offset by a reduction of year-
end audit fees, overall audit and review fees paid by the company to
the auditors would increase.
Disclosure Related to the Functioning of the Audit Committee
The principal benefits of the proposals are improved disclosure
relating to the functioning of corporate audit committee and enhanced
reliability and credibility of financial statements. The benefits of
improved disclosure regarding the audit committee's communications are
not readily quantifiable. We believe, however, that they would include
increased market efficiency due to improved information and investor
confidence in the reliability of companies' financial disclosures. We
request your comments and empirical data on whether the improved
disclosure will have that result.
We believe the costs associated with this proposal would derive
principally from the corresponding disclosure obligations; this is
because we are not placing any substantive requirements on audit
committees or their members. Based on the staff's experience with proxy
and information statements, and analogous cost estimates, we believe
that the additional disclosure contemplated by the proposed amendments
would, on average, require approximately three-fourths of a page in a
company's proxy or information statement. A financial printing company
informed the staff that adding up to three-fourths of a page in the
proxy statement would not likely increase the printing cost to the
company. That is because up to an extra three-fourths of a page can
normally be incorporated without increasing the page length by
reformatting the document. The printer reported that adding more than
three-fourths of a page could increase costs by about $1,500 for an
average sized company. Accordingly, based on our preliminary estimates,
there should be little, if any, additional printing costs from these
additional disclosures. We seek your comments on the accuracy of these
cost estimates, and we ask you to submit cost data to support your
analysis.
We believe, however, that disclosure required by the proposed
amendments could result in other costs. First, some companies may be
required to set up procedures to monitor the activities of the audit
committee in order to collect and record the information required by
the proposed amendments. In our view, such monitoring costs are most
likely to result from the proposed disclosure of the audit committee's
discussions with management and the independent auditors and receipt of
disclosures and a letter from the independent auditors.
Second, some companies may seek the help of outside experts,
particularly outside legal counsel, in formulating responses to the new
requirements. In some circumstances, for instance, the audit committee
may seek the advice of legal counsel before making the required
[[Page 55659]]
disclosure about the audited financial statements. We request your
comments, including supporting data, on the magnitude of these costs
and any other costs that we may not have mentioned.
For purposes of the Paperwork Reduction Act, we estimate that our
proposed disclosures would, on average, impose one additional burden
hour on each filer of Schedule 14A or 14C, or an aggregate annual total
of 15,445 additional burden hours. That estimate is based on current
burden hour estimates and the staff's experience with such filings. We
further estimate that approximately 75% of the extra burden hours, or
11,584 hours, will be expended by companies' internal staff, and the
remaining 25%, or 3,861 hours, by outside professional help.\86\ These
percentage estimates, which are based on current burden hour estimates
and the staff's experience with such filings, reflect the time
companies would spend preparing the additional disclosures in the proxy
statement or information statement.\87\ Assuming that the internal
staff costs the company an average of about $85 per hour, the aggregate
annual cost for internal staff assistance would amount to approximately
$980,000. If we assume that the outside professional assistance would
have an average cost of approximately $125 per hour, the aggregate
annual paperwork cost would be approximately $500,000. The total annual
costs would accordingly be about $1,500,000. We request your comments
on the reasonableness of these estimates and their underlying
assumptions.
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\86\ These assumptions are based on the staff's experience with
these filings. We believe that a company's internal staff will
typically carry most of the burden of preparing the proposed
additional disclosures, and will consult with outside professionals
only on specific issues that the company may periodically encounter
in preparing the proxy statement or information statement.
\87\ The estimate does not include the amount of time the audit
committee would spend conducting the discussions with the
independent accountants and management to which new Item 306 of
Regulation S-K and the amendments to Item 7 of Schedule 14A refer.
The amendments, if adopted, would not require that the audit
committee hold the discussions, but merely that it disclose whether
the discussions have taken place.
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These proposals are not intended to increase companies' or
directors' exposure to liability under federal or state law. Indeed, we
believe that the proposal will likely result in better and more
reliable financial reporting. As an extra safeguard, the proposed
amendments include liability ``safe harbors'' similar to that which
applies to compensation committee reports under current rules.\88\ We
nonetheless request your comments on whether the proposals could have
the unintended effect of increasing companies' and/or directors'
exposure to liability. Your comments should specifically address the
bases for liability concerns, including the underlying case law if
applicable, and your estimates of any additional costs that may result
from increased liability.
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\88\ See supra note 72.
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Are there any other costs or benefits that we have not identified?
Please identify them and provide data.
VII. Consideration of Impact on the Economy, Burden on Competition,
and Promotion of Efficiency, Competition and Capital Formation
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996,\89\ the Commission is requesting information regarding the
potential impact of the proposals on the economy on an annual basis.
Commentators should provide empirical data to support their views.
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\89\ Pub. L. No. 104-121, tit. II, 110 Stat. 857 (1996).
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Section 23(a) of the Exchange Act requires the Commission, when
adopting rules under the Exchange Act, to consider the anti-competitive
effects of any rule it adopts. We do not believe that the proposals
would have any anti-competitive effects since the proposals should
improve the transparency, reliability, and credibility of companies'
financial statements. We request comment on any anti-competitive
effects of the proposals. In addition, Section 3(f) of the Exchange Act
requires the Commission, when engaging in rulemaking that requires it
to consider or determine whether an action is necessary or appropriate
in the public interest, to consider whether the action will promote
efficiency, competition, and capital formation. We believe that the
proposals would bolster investor confidence in the securities markets
by improving the transparency of the role of corporate audit committees
and enhancing the reliability and credibility of financial statements
of public companies. Accordingly, the proposals should promote capital
formation and market efficiency. We request comment on these matters.
VIII. Initial Regulatory Flexibility Analysis
This Initial Regulatory Flexibility Analysis has been prepared in
accordance with 5 U.S.C. Sec. 603. It relates to proposed amendments to
rule 10-01 of Regulation S-X, Item 310 of Regulation S-B, and Item 7 of
Schedule 14A, under the Exchange Act, and proposed new Item 306 of
Regulations S-B and S-K.
A. Reasons for the Proposed Action
The new rules and amendments to current rules are being proposed to
improve disclosure relating to the functioning of corporate audit
committees and to enhance the reliability and credibility of financial
statements of public companies. The proposals are based in large
measure on recommendations recently made by the Blue Ribbon Committee
on Improving the Effectiveness of Corporate Audit Committees. The
required disclosure will help inform shareholders of the audit
committee's role in overseeing the preparation of the financial
statements and underscore the importance of the audit committee's
participation in the financial reporting process.
B. Objectives
The reviews required by our proposals should facilitate early
identification and resolution of material accounting and reporting
issues because the auditors will be involved earlier in the year. More
reliable interim financial information will be available to investors,
and early involvement of the auditor should reduce the number of
restatements or other year-end adjustments. We believe that the
proposed disclosures would reinforce the audit committee's awareness
and acceptance of its responsibilities, and make visible for
shareholders the audit committee's role in promoting reliable and
transparent financial reporting.
C. Legal Basis
The Commission is proposing the amendments and new rules pursuant
to its authority under Sections 2, 13, 14, and 23 of the Securities
Exchange Act.
D. Small Entities Subject to the Rule
The proposed amendments would affect small businesses that are
required to file proxy materials on Schedules 14A or 14C and Quarterly
Reports on Form 10-Q or 10-QSB, under the Exchange Act. Exchange Act
Rule 0-10 defines ``small business'' as a company whose total assets on
the last day of its most recent fiscal year were $5 million or less. We
estimate that there are approximately 830 reporting companies that are
not investment companies with assets of $5 million or less. The
Commission bases its estimate on information from the Insight database
from Compustat, a division of Standard and Poors.
Most reporting companies file either a proxy statement on Schedule
14A or an information statement on Schedule 14C, and all reporting
companies must file quarterly reports on Form 10-Q or 10-QSB. Some
companies are not subject to
[[Page 55660]]
the 14A or 14C requirements because their securities are not registered
under Section 12(b) or 12(g) under the Exchange Act. These companies
may, however, be subject to the Form 10-Q or Form 10-QSB requirements.
Because these requirements turn in part on the number of shareholders
and amount of assets--which are subject to change--we have no reliable
way to determine exactly how many reporting small businesses may be
affected by the rule proposals.
E. Reporting, Recordkeeping, and Other Compliance Requirements
Under the proposed rules, public companies, both large and small,
would be required to provide certain additional disclosure in their
proxy statements regarding the company's audit committee. Companies
would be required to include reports of their audit committees that
include disclosure about whether certain conversations between the
audit committee and management and the auditors took place. No
disclosure of the substance of the discussions is required.
1. Reviews of Quarterly Financial Statements
We propose to require companies to engage their independent
auditors to conduct interim reviews of their quarterly financial
statements prior to the company filing its Form 10-Q or 10-QSB. Based
on information provided to the Commission by the SECPS, it appears that
most companies engage their independent auditors to undertake some
level of review of their quarterly financial statements.
Medium and smaller sized accounting firms indicated to the SECPS
that SAS 71 reviews of small companies' interim financial statements
may cause delays in filing Forms 10-Q or 10-QSB, be relatively more
costly for all companies, be hampered by inadequate financial reporting
processes, and would result in small companies shifting financial
responsibilities from the company to the CPA firm. Firms providing
information to the SECPS also commented that the costs of compliance
would be partially offset by a reduction in year-end audit fees and
would lead to earlier identification of accounting and auditing issues
and an improvement in the quality of the process used for preparing
interim financial reports.
2. Disclosure Related to the Functioning of the Audit Committee
Some of the proposed amendments would increase disclosure of the
audit committee's role. The increased disclosure will require all
entities, large and small, to spend additional time and incur
additional costs in preparing disclosures. Smaller companies may incur
additional costs to set up procedures to monitor the activities of the
audit committee in order to collect and record the information required
by the proposed amendments. Smaller companies may also incur additional
costs in seeking the help of outside experts, particularly outside
legal counsel, in formulating responses to the new requirements.
F. Duplicative, Overlapping or Conflicting Federal Rules
The Commission believes that there are no rules that duplicate,
overlap, or conflict with the proposed rules.
G. Significant Alternatives
The Regulatory Flexibility Act directs the Commission to consider
significant alternatives that would accomplish the stated objectives,
while minimizing any significant adverse impact on small entities. In
connection with the proposed amendments, the Commission considered the
following alternatives: (a) The establishment of differing compliance
or reporting requirements or timetables that take into account the
resources available to small entities; (b) the clarification,
consolidation, or simplification of compliance and reporting
requirements under the rule for small entities; (c) the use of
performance rather than design standards; and (d) an exemption from
coverage of the rule, or any part thereof, for small entities.
We considered not applying the proposals to small business issuers.
We believe investors in smaller companies would want and benefit from
the disclosures about the audit committee and the advantages of interim
reviews just as much as investors in larger companies. In addition, the
COSO Report found that the incidence of financial fraud was greater at
small companies.\90\ The report specifically noted that the
``concentration of fraud among companies with under $50 million in
revenues and with generally weak audit committees highlights the
importance of rigorous audit committee practices, even for smaller
organizations.'' \91\ In light of the COSO Report, it may be
inconsistent with the purposes of the rule to exempt small business
issuers from the proposed requirement for interim reviews.
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\90\ See generally, COSO Report, supra note 76. In fact, the
COSO Report specifically found that a ``regulatory focus on
companies with market capitalization in excess of $200 million may
fail to target companies with greater risk for financial statement
fraud activities.'' Id. at 4.
\91\ Id. at 5.
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We also considered the alternative of only requiring companies
whose securities are listed on the NYSE or AMEX or quoted on Nasdaq to
include disclosures regarding the independence of their audit committee
members. We believe that the proposed amendments that require
disclosure regarding the independence of the members of their audit
committee impose only minimal additional costs but would provide useful
information to investors.
The proposed rule amendments and new rules are designed to improve
disclosure relating to the functioning of corporate audit committees
and to enhance the reliability and credibility of financial statements
for all public companies, and currently we do not believe it is
feasible to further clarify, consolidate or simplify the rule for small
entities.
H. Solicitation of Comments
The Commission encourages the submission of comments with respect
to any aspect of this Initial Regulatory Flexibility Analysis. In
particular, the Commission seeks comment on: (i) The number of small
entities that would be affected by the proposed rules; (ii) the nature
of the impact; and (iii) how to quantify the number of small entities
that would be affected by and/or how to quantify the impact of the
proposed rules. Comment is specifically requested regarding the number
of small entities that are not registered under Section 12 of the
Exchange Act that might be affected by the proposed amendments and what
effect, if any, they would have on small entities. Should there be
different requirements for those companies? Should those companies be
required to include the audit committee disclosures in their Forms 10-K
or 10-KSB, or in any other disclosure documents? Please describe the
nature of any impact and provide empirical data supporting the extent
of the impact. Such comments will be considered in the preparation of
the Final Regulatory Flexibility Analysis, if the proposed amendments
and new rules are adopted, and will be placed in the same public file
as comments on the proposed amendments and new rules themselves.
IX. Statutory Bases and Text of Amendments
We are proposing amendments to Rules 10-01 of Regulation S-X and
14a-101 (Schedule 14A) and Item 310 of Regulation S-B, and proposing
new Item 306 of Regulations S-K and S-B, under the authority set forth
in Sections 2, 13, 14, and 23 of the Exchange Act.
[[Page 55661]]
List of Subjects
17 CFR Part 210
Accountant, Accounting, Reporting and recordkeeping requirements,
Securities.
17 CFR Part 228
Reporting and recordkeeping requirements, Securities, Small
businesses.
17 CFR Parts 229 and 240
Reporting and recordkeeping requirements, Securities.
Text of Amendments
In accordance with the foregoing, Title 17, Chapter II of the Code
of Federal Regulations is proposed to be amended as follows:
PART 210--FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL
STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF
1934, PUBLIC UTILITY HOLDING COMPANY ACT OF 1935, INVESTMENT
COMPANY ACT OF 1940, AND ENERGY POLICY AND CONSERVATION ACT OF 1975
1. The authority citation for part 210 continues to read as
follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77aa(25),
77aa(26), 78j-l, 78l, 78m, 78n, 78o(d), 78u-5, 78w(a), 78ll(d),
79e(b), 79j(a), 79n, 79t(a), 80a-8, 80a-20, 80a-29, 80a-30, 80a-
37(a), unless otherwise noted.
2. By amending Sec. 210.10-01 by revising paragraph (d) to read as
follows:
Sec. 210.10-01 Interim financial statements.
* * * * *
(d) Interim review by independent public accountant. Prior to
filing, interim financial statements included in quarterly reports on
Form 10-Q (17 CFR 249.308(a)) must be reviewed by an independent public
accountant using professional standards and procedures for conducting
such reviews, as established by generally accepted auditing standards,
as may be modified or supplemented by the Commission. If, in any
filing, the company states that interim financial statements have been
reviewed by an independent accountant, a report of the independent
accountant on the review must be filed with the interim financial
statements.
* * * * *
PART 228--INTEGRATED DISCLOSURE SYSTEM FOR SMALL BUSINESS ISSUERS
3. The authority citation for part 228 continues to read as
follows:
Authority: 15 U.S.C. 77e, 77f, 77g, 77h, 77j, 77k, 77s, 77z-2,
77aa(25), 77aa(26), 77ddd, 77eee, 77ggg, 77hhh, 77jjj, 77nnn, 77sss,
78l, 78m, 78n, 78o, 78u-5, 78w, 78ll, 80a-8, 80a-29, 80a-30, 80a-37,
80b-ll, unless otherwise noted.
4. Sec. 228.305 is added and reserved and Sec. 228.306 is added to
read as follows:
Sec. 228.305 [Reserved]
Sec. 228.306 (Item 306) Audit committee report .
(a) The audit committee must state whether:
(1) The audit committee has reviewed and discussed the audited
financial statements with management;
(2) The audit committee has discussed with the independent auditors
the matters required to be discussed by SAS 61, as may be modified or
supplemented;
(3) The audit committee has received the written disclosures and
the letter from the independent accountants required by Independence
Standards Board Standard No. 1 (Independence Standards Board Standard
No. 1, Independence Discussions with Audit Committees), as may be
modified or supplemented, and has discussed with the independent
accountant the independent accountant's independence; and
(4) Based on the review and discussions referred to in paragraphs
(a)(1) through (a)(3) of this Item, anything has come to the attention
of the members of the audit committee that caused the audit committee
to believe that the audited financial statements included in the
company's Annual Report on Form 10-KSB (17 CFR 249.310b) for the year
then ended contain an untrue statement of a material fact or omit to
state a material fact necessary to make the statements made, in light
of the circumstances under which they were made, not misleading.
(b) The name of each member of the company's audit committee (or,
in the absence of an audit committee, the board committee performing
equivalent functions or the entire board of directors) must appear
below the disclosure required by this Item.
(c) The information required by paragraphs (a) and (b) of this Item
shall not be deemed to be ``soliciting material,'' or to be ``filed''
with the Commission or subject to Regulation 14A or 14C (17 CFR
240.14a-1 et seq. or 240.14c-1 et seq.), other than as provided in this
Item, or to the liabilities of section 18 of the Exchange Act (15
U.S.C. 78r), except to the extent that the company specifically
requests that the information be treated as soliciting material or
specifically incorporates it by reference into a document filed under
the Securities Act or the Exchange Act.
(d) The information required by paragraphs (a) and (b) of this Item
need not be provided in any filings other than a registrant proxy or
information statement relating to an annual meeting of security holders
at which directors are to be elected (or special meeting or written
consents in lieu of such meeting). Such information will not be deemed
to be incorporated by reference into any filing under the Securities
Act or the Exchange Act, except to the extent that the registrant
specifically incorporates it by reference.
5. By amending Sec. 228.310 by revising the introductory text of
paragraph (b) to read as follows:
Sec. 228.310 (Item 310) Financial Statements.
* * * * *
(b) Interim Financial Statements. Interim financial statements may
be unaudited; however, prior to filing, interim financial statements
included in quarterly reports on Form 10-QSB (17 CFR 249.308b) must be
reviewed by an independent public accountant using professional
standards and procedures for conducting such reviews, as established by
generally accepted auditing standards, as may be modified or
supplemented by the Commission. If, in any filing, the issuer states
that interim financial statements have been reviewed by an independent
public accountant, a report of the accountant on the review must be
filed with the interim financial statements. Interim financial
statements shall include a balance sheet as of the end of the issuer's
most recent fiscal quarter and income statements and statements of cash
flows for the interim period up to the date of such balance sheet and
the comparable period of the preceding fiscal year.
PART 229--STANDARD INSTRUCTIONS FOR FILING FORMS UNDER SECURITIES
ACT OF 1933, SECURITIES EXCHANGE ACT OF 1934 AND ENERGY POLICY AND
CONSERVATION ACT OF 1975--REGULATION S-K
6. The authority citation for part 229 continues to read in part as
follows:
Authority: 15 U.S.C. 77e, 77f, 77g, 77h, 77j, 77k, 77s, 77z-2,
77aa(25), 77aa(26), 77ddd, 77eee, 77ggg, 77hhh, 77iii, 77jjj, 77nnn,
77sss, 78c, 78i, 78j, 78l, 78m, 78n, 78o, 78u-5, 78w, 78ll(d), 79e,
79n, 79t, 80a-8, 80a-29, 80a-30, 80a-37, 80b-11, unless otherwise
noted.
* * * * *
[[Page 55662]]
7. By adding Sec. 229.306 to read as follows:
Sec. 229.306 (Item 306) Audit committee report.
(a) The audit committee must state whether:
(1) The audit committee has reviewed and discussed the audited
financial statements with management;
(2) The audit committee has discussed with the independent auditors
the matters required to be discussed by SAS 61, as may be modified or
supplemented;
(3) The audit committee has received the written disclosures and
the letter from the independent accountants required by Independence
Standards Board Standard No. 1 (Independence Standards Board Standard
No. 1, Independence Discussions with Audit Committees), as may be
modified or supplemented, and has discussed with the independent
accountant the independent accountant's independence; and
(4) Based on the review and discussions referred to in paragraphs
(a)(1) through (a)(3) of this Item, anything that has come to the
attention of the members of the audit committee that caused the audit
committee to believe that the audited financial statements included in
the company's Annual Report on Form 10-K (17 CFR 249.310) for the year
then ended contain an untrue statement of a material fact or omit to
state a material fact necessary to make the statements made, in light
of the circumstances under which they were made, not misleading.
(b) The name of each member of the company's audit committee (or,
in the absence of an audit committee, the board committee performing
equivalent functions or the entire board of directors) must appear
below the disclosure required by this Item.
(c) The information required by paragraphs (a) and (b) of this Item
shall not be deemed to be ``soliciting material,'' or to be ``filed''
with the Commission or subject to Regulation 14A or 14C (17 CFR
240.14a-1 et seq. or 240.14c-1 et seq.), other than as provided in this
Item, or to the liabilities of section 18 of the Exchange Act (15
U.S.C. 78r), except to the extent that the company specifically
requests that the information be treated as soliciting material or
specifically incorporates it by reference into a document filed under
the Securities Act or the Exchange Act.
(d) The information required by paragraphs (a) and (b) of this Item
need not be provided in any filings other than a registrant proxy or
information statement relating to an annual meeting of security holders
at which directors are to be elected (or special meeting or written
consents in lieu of such meeting). Such information will not be deemed
to be incorporated by reference into any filing under the Securities
Act or the Exchange Act, except to the extent that the registrant
specifically incorporates it by reference.
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
8. The authority citation for part 240 continues to read, in part,
as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee,
77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k,
78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d),
78mm,79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-
11, unless otherwise noted.
* * * * *
9. By amending Sec. 240.14a-101 by adding paragraph (3) to Item
7(e) to read as follows:
Sec. 240.14a-101 Schedule 14A. Information required in proxy
statement.
* * * * *
Item 7. Directors and executive officers. * * *
(e) * * *
(3) If the registrant has an audit committee:
(i) Provide the information required by Item 306 of Regulation
S-K (17 CFR 229.306).
(ii) State whether the company's audit committee has adopted a
written charter.
(iii) Include a copy of the written charter, if any, as an
appendix to the company's proxy statement unless a copy has been
included as an appendix to the company's proxy statement within the
company's past three fiscal years.
(iv)(A) For companies whose securities are listed on the New
York Stock Exchange (``NYSE'') or American Stock Exchange (``AMEX'')
or quoted on Nasdaq, if the company's Board determines in accordance
with the requirements of section 303.02(D) of the NYSE's listing
standards, section 121(B)(b)(ii) of the AMEX's listing standards, or
section 4310(c)(26)(B)(ii) or 4460(d)(2)(B) of the National
Association of Securities Dealers' (``NASD'') listing standards, as
applicable and as may be modified or supplemented, to appoint one
director to the audit committee who is not independent (as
independence is defined in Sections 303.01(B)(2)(a) and (3) of the
NYSE's listing standards, section 121(A) of the AMEX's listing
standards, or Rule 4200(a)(15) of the NASD's listing standards, as
applicable and as may be modified or supplemented), disclose the
nature of the relationship that makes that individual not
independent and the reasons for the Board's determination. Small
business issuers are not required to comply with this paragraph
(e)(3)(iv)(A).
(B) For companies, including small business issuers, whose
securities are not listed on the NYSE or AMEX or quoted on Nasdaq,
disclose whether, if the company has an audit committee, the members
are independent. In determining whether a member is independent, the
company must use the definition of independence in section
303.01(B)(2)(a) and (3) of the NYSE's listing standards, section
121(A) of the AMEX's listing standards or Rule 4200(a)(15) of the
NASD's listing standards, as such sections may be modified or
supplemented, and state which of these definitions was used.
Whichever definition is chosen must be applied consistently to all
members of the audit committee.
(v) The information required by paragraph (e)(3) of this Item
shall not be deemed to be ``soliciting material,'' or to be
``filed'' with the Commission or subject to Regulation 14A or 14C
(17 CFR 240.14a-1 et seq. or 240.14c-1 et seq.), other than as
provided in this Item, or to the liabilities of Section 18 of the
Exchange Act (15 U.S.C. 78r), except to the extent that the company
specifically requests that the information be treated as soliciting
material or specifically incorporates it by reference into a
document filed under the Securities Act or the Exchange Act. Such
information will not be deemed to be incorporated by reference into
any filing under the Securities Act or the Exchange Act, except to
the extent that the registrant specifically incorporates it by
reference.
(vi) Investment companies registered under the Investment
Company Act of 1940 (15 U.S.C. 80a-1 et seq.), other than closed-end
investment companies, need not provide the information required by
this paragraph (e)(3).
* * * * *
By the Commission.
Dated: October 7, 1999.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-26791 Filed 10-13-99; 8:45 am]
BILLING CODE 8010-01-P
