SEC Update

Winter 2000

Executive Summary

The Securities Exchange Commission (SEC) adopted new regulations which affect financial reporting and audit committees of public companies. The SEC also approved similar changes to the listing standards and corporate governance provisions of the NYSE, the AMEX, and the Nasdaq Stock Market. The new regulations are intended to improve the reliability and credibility of financial statements of public companies. The new regulations are also intended to address the SEC's long standing concerns regarding inappropriate "earnings management" and pressures to meet earnings expectations. The SEC hopes that the new rules will reduce the need for year-end adjustments and restatements of financial results, and facilitate early identification and resolution of material accounting and reporting issues.

The new regulations aim to achieve these goals by increasing the level of scrutiny of quarterly financial statements and the oversight responsibilities of audit committee members. The new regulations will impact public companies as follows:

Companies must have their quarterly financial statements reviewed by their auditors before they are filed with the SEC on Form 10-Q or 10-QSB.
All companies (except small business companies reporting on small business forms) must include selected quarterly financial data disclosures in their 10-K reports.
Companies must adopt an audit committee charter which must be reviewed annually and filed with the SEC every three years.
Proxy statements must include an audit committee report over the printed name of each member of the audit committee.
Audit committee members must comply with new standards regarding their independence and financial literacy.

Auditor Review of Quarterly Financial Statements Is Now Required

Beginning in the quarter that ends on or after March 15, 2000, outside auditors must conduct timely quarterly reviews of financial statements before they are filed with the SEC on Form 10-Q or 10-QSB. The auditors must review the financial statements using "professional standards and procedures for conducting such reviews, as established by generally accepted auditing standards." The SEC has indicated that under current auditing standards, this means compliance with the procedures set forth in SAS 71. The required review need not be completed before public announcement of quarterly results, or the quarterly "earnings press release."

Selected Quarterly Data is Now Required

After December 15, 2000, companies must supplement their annual financial information with disclosure of selected quarterly financial data in the company's 10-K reports. In connection with such disclosure, companies must also provide reconciliation and descriptions of any adjustments to the quarterly financial information previously reported for any quarter. The company's auditors must review the selected quarterly data pursuant to SAS 71.

Small business companies reporting on small business company forms, and companies that do not have a class of securities registered under Sections 12(b) or 12(g), need not provide the selected quarterly data.

Prior to this amendment, selected quarterly data was required of only larger public companies.

An Audit Committee Charter is Now Required

Companies that are listed on the NYSE or AMEX or are quoted on Nasdaq are required to adopt an audit committee charter by June 14, 2000. The charter must be reviewed and its adequacy reassessed on an annual basis. At a minimum, the charter should specify:

The scope of the audit committee's responsibilities and how they are being carried out, including the structure, processes and membership requirements of the committee.
That the auditor is ultimately accountable to the board of directors and the audit committee, and that the committee and the board have the ultimate authority to select, evaluate and replace the auditor.
That the audit committee is responsible for ensuring that the auditors submit a formal written statement regarding any relationships between the auditors and the company, and that the committee must engage in a dialogue with the auditor regarding any disclosed relationships and the continued independence of the auditor.

The requirement to adopt a charter stems from the requirements of the NYSE, AMEX and Nasdaq. Companies whose securities are not listed on the NYSE or AMEX or not quoted on the Nasdaq are not required, although certainly encouraged, to establish an audit committee and adopt an audit committee charter.

Commentary on this topic suggests that standards imposed on audit committees in the charter could provide a basis for liability if these standards are reached. As a result, companies should exercise caution to ensure that liability will not arise from the committee's failure to meet any duties and "aspirational" standards embodied in the charter.

New SEC Disclosure Items. For shareholder meetings occurring after December 15, 2000, the proxy statement must specify whether the audit committee has adopted a charter. If a charter has been adopted, it must be filed with the SEC as an appendix to the proxy statement and every three years thereafter.

Audit Committee Report is Now Required

For shareholder meetings occurring after December 15, 2000, companies must include an audit committee report in their annual proxy statements over the printed name of each audit committee member.

The audit committee report must discuss the nature and scope of the audit committee's dialogue with the auditors. The report must state whether:

The committee has reviewed and discussed the audited financial statements with management.
The committee has discussed with auditors matters required to be discussed by SAS 61.
The committee has received written disclosures from the auditors required by ISB Standard No. 1 and has discussed with the auditors their independence.
The committee recommended to the full board that the audited financial statements be included in the company's annual report on Form 10-K or 10-KSB for the last fiscal year, based on the review and discussion referred to above.

The audit committee report is required in a proxy statement which relates to an annual meeting of shareholders where directors will be elected (or special meeting or written consent in lieu of such meeting).

Audit Committee Members Must Be Independent and Financially Literate

New rules of the NYSE, AMEX and Nasdaq set forth new qualifications for audit committee members. Audit committees must consist of at least three members, all of whom are independent and financially literate. A NYSE company that has fewer than three audit committee members has until June 14, 2000 to recruit additional members. However, all audit committee members reelected or replaced after December 14, 1999 must be independent and financially literate.

Nasdaq and AMEX companies have until June 14, 2001 to comply. Small business companies quoted on Nasdaq must maintain an audit committee of at least two directors, a majority of which are independent.

Independence. The determination of who is an independent and financially literate director to serve on an audit committee is slightly different under the NYSE listing standards than under the AMEX/Nasdaq listing standards. Generally, under all three standards, a director is independent if that director is not, and has not in the past three years been, an officer, employee of the company or an immediate family member of such officer or employee. The member also cannot be a controlling shareholder or an executive officer of another company that has a business relationship with the company and cannot have certain other business relationships with the company. Certain compensation committee interlocks also disqualify a member from being "independent."

Financial Literacy. A member of an audit committee must be financially literate. The NYSE rules do not define the term. The Nasdaq/AMEX rules specify that members must be able to read and understand fundamental financial statements.

Both the NYSE and Nasdaq/AMEX rules mandate that at least one member of the audit committee can demonstrate financial sophistication through past employment experience in finance or accounting or through professional accounting certification.

Commentary of the new qualification requirements on audit committees suggests that companies should consider adopting a questionnaire for existing and new audit committee members to make sure the qualification requirements are met.

New SEC Disclosure Requirements. The annual proxy statement must state whether audit committee members are independent. If the company has appointed a non-independent member to its audit committee, it must disclose the relationship which makes the member non-independent and must also disclose the reasons for appointing a non-independent member in the company's next annual proxy statement.

If the company is not listed on the NYSE or AMEX and not quoted on the Nasdaq, the company must choose the requirements of the NYSE, AMEX or Nasdaq, apply those standards to the members of its audit committees and provide the required disclosure on independence.

Safe Harbor and Exclusions

The newly required audit committee disclosures in annual proxy statements are not considered soliciting materials, filed with the SEC or subject to regulation 14A or 14C. This means that the new disclosures are not subject to the anti-fraud provisions of Rule 14a-9 or 14c-6 or the liability provisions of Section 18 of the Securities Exchange Act of 1934. The SEC declined to adopt a safe-harbor provision from private litigation. The audit committee disclosures are treated the same as the currently required compensation committee report and will not be deemed incorporated by reference into any fling under the securities Act or the Exchange Act.

The safe harbor provided by the SEC only applies to SEC disclosure. The safe harbor does not affect the potential liability of audit committee members or the company for failure to

The articles on our Web site include some of the publications and papers authored by our attorneys, both before and after they joined our firm. The content of these articles should not be taken as legal advice or as an expression of the views of the firm, its attorneys or any of its clients. We hope the articles spur discussion in the legal community with insight into the experience of the authors. We expressly reserve the right in the future to become wiser or simply change our mind.

Robins, Kaplan, Miller, & Ciresi, L.L.P.

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