United States: SEC Proposes Rules Implementing Section 301 of the Sarbanes-Oxley Act of 2002: SEC to Propose Listing Standard Requirements for National Securities Exchanges and National Securities Associations Regarding Audit Committees

The Securities and Exchange Commission (the "SEC" or the "Commission") today approved the publication of proposed Exchange Act Rule 10A-3 implementing Section 10A(m)(1) of the Exchange Act of 1934, as added by Section 301 of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act" or the "Act"). This proposal will implement the requirement of the Sarbanes-Oxley Act that the SEC direct the national securities exchanges and national securities associations to refuse listing of securities of issuers whose audit committees do not comply with the five requirements specified in the Act. These five requirements relate to: the independence of audit committee members; the audit committee’s responsibility to select and oversee the issuer’s independent accountant; procedures for handling complaints regarding accounting or auditing matters; the authority of the audit committee to engage advisors; and funding for the outside auditor and any outside advisors engaged by the audit committee. The proposed rule implements all five of these requirements.

The SEC will post the proposing release, including the text of the proposed rule, to its website after the proposed rule is officially issued. This summary is based on information provided at the SEC’s open meeting and in the Commission’s press release, and therefore may not reflect nuances that appear in the official text. Interested parties will have an opportunity to comment on the proposal during the 30-day period following publication in the Federal Register.

1. Definition of Independence

Under Section 301 of the Sarbanes-Oxley Act, listed companies must have audit committees consisting entirely of independent directors. The Act provides that, to be independent, an audit committee member must not accept any "consulting, advisory or other compensatory fee" from the issuer, other than amounts received as compensation for membership on the board of directors, the audit committee, or any other committee. The concept of "consulting, advisory, or other compensatory fee" is not clarified or altered by the proposed rule.

The Act also provides that independence requires an audit committee member not be an "affiliated person" of the issuer or any subsidiary of the issuer. This proposal will prohibit the affiliation of an audit committee member either directly or indirectly through a spouse or an entity of which the person is a member, partner or principal. The staff indicated that the proposed rule’s definition of "affiliated person" will be consistent with current SEC definitions, including Rule 144 under the Securities Act of 1933, which defines an "affiliate" of an issuer as "a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer." The staff also indicated that this definition would include a safe harbor similar to one proposed in 1997, namely that as long as a person is not an executive officer, director, or 10% shareholder, that person will not be deemed to control the issuer.

2. Accommodation for New Issuers

The proposal makes one accommodation to ease the burden of the independence requirement on new issuers. It provides that a new issuer will be permitted to maintain one non-independent director on its audit committee for the first 90 days the issuer is listed.

3. Accommodations for Holding Companies

The proposal also makes an accommodation for holding companies, where the same person serves on the boards of directors of both a parent company and its subsidiary. Such service will not disqualify the director from serving on either company’s audit committee, as long as the other requirements for independence are met.

4. Accommodations for Foreign Issuers

The proposed rule does not provide a general exemption for foreign issuers. However, recognizing that foreign issuers are often governed by corporate governance laws or listing standards that might be inconsistent with the Sarbanes-Oxley Act, but which provide adequate shareholder protections, the proposal accommodates foreign issuers in the following ways:

• Where foreign laws require that shareholders select, approve, or ratify an issuer’s independent auditors, an exemption from the requirements of Section 301 will be made.
  
• Where a foreign jurisdiction requires companies to include employee representatives on the board of directors, an employee director will be permitted to sit on the audit committee as long as that person is not an executive officer of the issuer.
  
• Where a company is governed by laws requiring that a foreign government representative serve on the board of directors, that foreign government representative may also serve on the audit committee if he or she is not an executive officer of the issuer.
  
• Since foreign companies are often owned by families or other large shareholders, one representative of a 50% or greater shareholder may serve on a company’s audit committee as long as that member has only observer status, and is not allowed to vote or serve as the chair of the committee.
  
• Where foreign laws require an issuer to have a board of auditors or a group of statutory auditors, which auditors are not members of the board of directors, the proposal contains exemptions from certain of its requirements.

5. Reporting Requirements

The proposal also updates existing SEC disclosure requirements relating to audit committees. These include the disclosure of the use of any exemptions in the rule, the identification of the audit committee in annual reports, and disclosures concerning the audit committee’s independence in proxy statements. This latter disclosure will require non-listed companies to choose a definition of "independent" from among those used in the listing standards of the New York Stock Exchange, the NASDAQ Stock Market, and the American Stock Exchange. In all other respects, the proposed rule only affects listed companies.

6. Timing

The proposal will require the national securities exchanges and national securities associations to have new listing standards in place within one year from the date the SEC’s final rule becomes effective (the SEC rule will become effective no later than April 26, 2003). This one-year transition period is being proposed to give companies the opportunity reconstitute their audit committees as necessary to comply with the new listing requirements.

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