Risk & Compliance

Audit Committees Face SEC Heat

New rules drawn up by the SEC could greatly add to the level of responsibility for outside directors.
Ed ZwirnNovember 22, 2000

Conjure up the stereotype of an outside director and you’re likely to see a former President, senator or other dignitary getting paid to do little more than attend some meetings and lend prestige to a firm.

But publicly held U.S. corporations will soon need to pay closer attention to the selection of outside directors, particularly those who sit on board audit committees.

In a move Securities and Exchange Commission Chairman Arthur Levitt called “a very important cultural change” for U.S. business, the SEC placed much of the onus for ensuring auditor independence on these committees.

The roughly 300 pages of regulations, which were published Tuesday, Nov. 21, were written after the SEC compromised with the Big 5 accounting firms and let them preserve their lucrative non-audit activities for their audit clients, including IT consulting. Click here for complete text.

While a proposal the SEC published June 27 would have prohibited much of this activity outright, the compromise approved unanimously last week requires that companies disclose in annual proxy statements the fees they paid out for these services.

According to a fact sheet distributed by the SEC last week, companies are now required to “state whether the audit committee has considered whether the provision of the non- audit services is compatible with maintaining auditor’s independence.”

Also, the firm would have to disclose hours worked on the audit by “persons other than the accountant’s full-time employees, if that figure exceeded 50 percent.”

The latest changes, which will be phased in over a 20-month period following their publication in the Federal Register, come nearly a year after regulators last altered audit committees’ responsibilities.

Among the changes enacted by the SEC in December 1999, was a requirement that audit committees include at least three outside directors, one of whom should have financial expertise.

Last year’s rule changes are just now taking effect, and in most cases will become operative as of the first annual shareholder meeting after December 2000.

As of press time, none of the sources contacted by CFO.com had yet had a chance to study the new auditor independence regulations. But reaction to the guidelines approved last week by the SEC runs the gamut from unqualified approval to concern about their role in increasing liability for audit committee members and the firms they serve.

“The rule does indeed strengthen the role of audit committees,” says Steven Silber, a spokesman for PricewaterhouseCoopers, a Big 5 firm that reportedly endorsed the compromise rule.

“I think company management will see to it now that there are people sitting on audit committees that have the expertise to enforce these rules,” he adds.

According to Jack Flug, an attorney with Marsh, the big insurance broker, the new rules should have a limited impact on the extent to which firms or individuals incur liability since the major hit has already occurred.

“The short answer is that the big rule was set in place a year ago,” he says. The new rule is a “companion” to the older one, “since it’s an expansion of what’s already there,” he adds.

But for those on an audit committee, things are now “definitely more complicated than merely going to a few meetings,” he says.

From an insurance standpoint, while the new SEC ruling “probably does increase the potential for liability, the general negligence issues to which audit committees are exposed are “already covered by director and officer liability” policies, the Marsh attorney says.

According to Flug, the D&O policies offered by most insurers are sufficient to protect against most liability incurred specifically by audit committee members as a result of the new regulations. There are policies available specifically designed for audit committees, but these are for the type of people that “wear both a belt and suspenders.”

On the other hand, Flug admitted, there is the possibility that coverage could be jeopardized if lack of compliance with the new regulations forces a firm to restate a financial statement. For more on restatements, click here.

William J. Schnoor, a partner and member of the Business Practice Group at Testa, Hurwitz & Thibeault, a Boston law firm, points out that the SEC’s rules place the emphasis on disclosure rather than regulation and penalties.

“The SEC doesn’t say you have to do this [avoid conflicts that may jeopardize auditor independence], it says you have to say whether or not you did it,” he says.

Still, the full extent of audit committee members’ liability won’t be determined until the courts establish a legal precedent, and that will probably take years.

“The SEC, within [the rules passed December 1999], says this audit committee report is not to become a liability,” he says. “But plaintiff’s lawyers are already working very hard to spin this as a personal liability issue.”

4 Powerful Communication Strategies for Your Next Board Meeting