After a year-long campaign against accounting abuses that inflate earnings, the US Securities&Exchange Commission (SEC) has issued its long-awaited directives concerning these “earnings management” practices.
Companies may now feel these decrees provide them with guidelines to avoid the kind of SEC prosecutions that have earned brand-name companies unwanted publicity – not to mention attacks from the plaintiff bar.
They may be wrong.
One of the “hot buttons” for SEC chairman Arthur Levitt has been a company’s audit committee, which is responsible for policing Financial statements. Examples abound, he charges, of committees whose members hardly ever meet, lack expertise in the basic principles of Financial reporting or don’t have a mandate to really probe for problems. “Qualified, committed, independent and tough-minded audit committees,” he said, “represent the most reliable guardians of the public interest.”
But a number of new rules adopted by the SEC, the stock exchanges and the National Association of Securities Dealers to accomplish this are likely to drive away the people who can get the job done.
Many of the rules are not terribly controversial, such as that independent auditors must review quarterly Financials before they are Filed with the SEC. And audit committees must consist of directors who have no relationships that may interfere with the independent exercising of their duties.
Other rules are more troubling. The board of directors must now Find that each member of the audit committee is “Financially literate” and at least one member must have “accounting or related Financial management expertise”.
But what does that mean? The New York Stock Exchange standards, are not set out in the rules and are by their very nature subjective.
Furthermore, they will be subject to interpretation and implementation by the board in the exercise of its business judgement.
Given this lack of objective standards, it may be extremely difficult for the board to even define its criteria, much less defend them if the qualifications of its audit committee members are challenged in a lawsuit.
Even without this complication, companies now have the added burden of seeking out board candidates who possess both Financial literacy and the broad spectrum of general management expertise so essential to the effective exercise of a director’s duties.
But the most dangerous rule mandates that companies include reports in their proxy statements that disclose whether the audit committee has reviewed and discussed the audited Financial statements with management, reviewed with the independent accountants matters related to the conduct of the audit, and received disclosures from the independent accountants regarding their independence and discussed the issue with them.
The report then must disclose whether, based on these reviews and discussions, the audit committee blessed the Financial statements for inclusion in the company’s annual report Filed with the SEC.
In making audit committees the keeper of the good housekeeping seal of approval for Financial statements, the rules are creating higher standards that are likely to impose greater personal liability on audit committee directors. Some observers have quipped that a board member who chooses to sit on the committee under these circumstances is, by definition, Financially illiterate. But the impact is serious. This provision will deter talented individuals from serving on audit committees.
Lastly, the new rules will make it difficult for companies to rotate directors among their various committees. This will limit the ability of directors to gain board committee experience and greater knowledge of the company, both of which would ultimately have a positive impact on their overall effectiveness as directors. The net result of all of these rules will be to shrink the pool of potential audit committee members and perhaps drive capable sitting members away.
There are several simple, obvious steps companies can take – though history indicates that many won’t – to protect their boards and audit committees from potential liability stemming from the new rules. Taking these measures will help prove – in court or otherwise – that your Firm made a good-faith effort to comply with the rules. This could protect a company from liability even when these efforts fail to prevent abuse.
In order to ascertain and document the requisite Financial literacy of the audit committee members, companies should consider using a questionnaire designed to elicit the academic, vocational and other relevant experiences of the prospective members of the committee. This process would help establish that the board was diligent in selecting its audit committee.
It is important to reduce the risk that shareholders will misconstrue the responsibilities of the audit committee set out in its charter or in its report in the proxy statement. Thus, audit committee charters should include a cautionary statement indicating that the role of the audit committee is limited and circumscribed. The point is to make it clear that the audit committee’s review is not of a higher order than the outside auditor’s or than the role management plays in preparing the Financial statements.
The charter should be reviewed to ensure that it is limited to those responsibilities that the rules contemplate. A number of companies combine the functions of a Finance committee with those of an audit committee or include in the audit committee’s responsibilities functions that could be performed by other committees or the board itself. As the audit committee action will be judged against what the charter calls for, it is also better to describe its activities in more general terms rather than setting forth with great specificity the steps it is required to take to fulfil its responsibilities. The practice of a number of companies today is to be very detailed in the charter.
What a number of commentators feared when the rules were proposed has in fact happened. The new rules have created two classes of directors, with those serving on the audit committee being exposed to claims based on a more onerous duty of care than is applicable to the other directors. While the rules seek to strengthen the audit committee, they may, in effect, be weakening it by discouraging the best and the brightest from serving.
Mark Kessel, who is a director on several boards, is a partner in the international law firm of Shearman&Sterling
