| Release No. 33-8220 Release No. 34-47654 Release No. IC-26001 68 Fed. Reg. 18787 - Apr. 16, 2003
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 Table of Contents
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I. Background and Overview of the New Rule and Amendments
In this release, we implement Section 10A(m)(1) of the Exchange Act,13 as added by Section 301 of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act"),14 which requires us to direct, by rule, the national securities exchanges15 and national securities associations16 (or "SROs") to prohibit the listing of any security of an issuer that is not in compliance with several enumerated standards regarding issuer audit committees. We received over 185 comments in response to our release proposing to implement the directive in Section 10A(m) of the Exchange Act.17 The final rule and form amendments we adopt today have been revised, as discussed in this release, to incorporate a number of changes recommended by commenters.
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. Investor confidence in the reliability of corporate financial information is fundamental to the liquidity and vibrancy of our markets.
Effective oversight of the financial reporting process is fundamental to preserving the integrity of our markets. The board of directors, elected by and accountable to shareholders, is the focal point of the corporate governance system. The audit committee, composed of members of the board of directors, plays a critical role in providing oversight over and serving as a check and balance on a company's financial reporting system. The audit committee provides independent review and oversight of a company's financial reporting processes, internal controls and independent auditors. It provides a forum separate from management in which auditors and other interested parties can candidly discuss concerns. By effectively carrying out its functions and responsibilities, the audit committee helps to ensure that management properly develops and adheres to a sound system of internal controls, that procedures are in place to objectively assess management's practices and internal controls, and that the outside auditors, through their own review, objectively assess the company's financial reporting practices.
Since the early 1940s, the Commission, along with the auditing and corporate communities, has had a continuing interest in promoting effective and independent audit committees.18 It was largely with the Commission's encouragement, for instance, that the SROs first adopted audit committee requirements in the 1970s.19 Over the years, others have expressed support for strong, independent audit committees,20 including the National Commission on Fraudulent Financial Reporting, also known as the Treadway Commission,21 and the General Accounting Office.22
In 1998, the NYSE and the NASD sponsored a committee to study the effectiveness of audit committees. This committee became known as the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (the "Blue Ribbon Committee"). In its 1999 report, the Blue Ribbon Committee recognized the importance of audit committees and issued ten recommendations to improve their effectiveness.23 In response to these recommendations, the NYSE and the NASD, among others, revised their listing standards relating to audit committees,24 and we adopted new rules requiring disclosure relating to the functioning, governance and independence of corporate audit committees.25 Beginning last year, at the Commission's request,26 the NYSE and the NASD again reviewed their corporate governance standards, including their audit committee rules, in light of several high-profile corporate failures, and have proposed changes to their rules to provide more demanding standards for audit committees.27
Recent events involving alleged misdeeds by corporate executives and independent auditors have damaged investor confidence in the financial markets.28 They have highlighted the need for strong, competent and vigilant audit committees with real authority.29 In response to the threat to the U.S. financial markets posed by these events, Congress passed, and the President signed into law on July 30, 2002, the Sarbanes-Oxley Act. The Sarbanes-Oxley Act mandates sweeping corporate disclosure and financial reporting reform to improve the responsibility of public companies for their financial disclosures. This release is the most recent of several that we have issued to implement provisions of the Sarbanes-Oxley Act.30
Under new Exchange Act Rule 10A-3, SROs will be prohibited from listing any security of an issuer that is not in compliance with the following standards, as discussed in more detail in this release:
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Each member of the audit committee of the issuer must be independent according to specified criteria;
The audit committee of each issuer must be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm31 engaged for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the issuer, and each such registered public accounting firm must report directly to the audit committee;
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Each audit committee must establish procedures for the receipt, retention and treatment of complaints regarding accounting, internal accounting controls or auditing matters, including procedures for the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters;
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Each audit committee must have the authority to engage independent counsel and other advisors, as it determines necessary to carry out its duties; and
Each issuer must provide appropriate funding for the audit committee.
With the exceptions specified below, listed issuers must be in compliance with the new listing rules by the earlier of (1) their first annual shareholders meeting after January 15, 2004, or (2) October 31, 2004. Foreign private issuers32 and small business issuers33 that are listed must be in compliance with the new listing rules by July 31, 2005.
In addition, the final rule amendments make several changes to our current disclosure requirements regarding audit committees.
II. Discussion
Under Section 3(a)(58) of the Exchange Act,34 as added by Section 205 of the Sarbanes-Oxley Act, the term audit committee is defined as:
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A committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer; and
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If no such committee exists with respect to an issuer, the entire board of directors of the issuer.
Accordingly, an issuer either may have a separately designated audit committee composed of members of its board or, if it chooses to do so or if it fails to form a separate committee, the entire board of directors will constitute the audit committee. If the entire board constitutes the audit committee, the new SRO rules adopted under Exchange Act Rule 10A-3, including the independence requirements, will apply to the issuer's board as a whole.
In addition, because Exchange Act Section 10A(m) imposes requirements that only apply to issuers listed on a national securities exchange or listed in an automated inter-dealer quotation system of a national securities association,35 the requirements of Exchange Act Rule 10A-3 only apply to issuers that are so listed. None of the requirements of Section 10A(m) of the Exchange Act or Exchange Act Rule 10A-3 apply to other reporting companies under Section 13(a)36 or 15(d)37 of the Exchange Act.38
Some commenters requested clarification regarding application of the rule to listed issuers organized as limited partnerships that do not have their own board of directors but instead rely on a managing general partner.39 We have added a clarification that in the case of a listed issuer that is a limited partnership or limited liability company where such entity does not have a board of directors or equivalent body, the term "board of directors" means the board of directors of the managing general partner, managing member or equivalent body.
A. Audit Committee Member Independence
1. Scope of the Requirement
As early as 1940, the Commission encouraged the use of audit committees composed of independent directors.40 An audit committee comprised of independent directors is better situated to assess objectively the quality of the issuer's financial disclosure and the adequacy of internal controls than a committee that is affiliated with management. Management may face market pressures for short-term performance and corresponding pressures to satisfy market expectations. These pressures could be exacerbated by the use of compensation or other incentives focused on short-term stock appreciation, which can promote self-interest rather than the promotion of long-term shareholder interest. An independent audit committee with adequate resources helps to overcome this problem and to align corporate interests with those of shareholders.
Our final rules enhance audit committee independence by implementing the two basic criteria for determining independence enumerated in Section 10A(m) of the Exchange Act, which are discussed in more detail below. Commenters expressed general overall support for the Commission's approach to implementing Section 10A(m) of the Exchange Act. Advocates of investors in particular endorsed the Commission's proposals, though not all believed that Section 10A(m) and the Commission's proposals went far enough.41 Several supported having the Commission mandate all independence requirements for listed issuers, not just those specified in Exchange Act Section 10A(m), as compared to the proposed approach of building on additional SRO standards for independence. However, a substantial number of commenters did not support having the Commission replace the SROs' role in setting additional criteria, preferring to leave additional requirements to the SRO rulemaking process with appropriate Commission oversight.42
As noted in the Proposing Release, in seeking to ensure appropriate levels of independence, we recognize that SROs currently restrict additional business or personal relationships.43 Further, several SROs are seeking significant improvements to tighten these requirements, in particular in the additional listing standards that are currently under consideration.44 We fully support the goals the SROs are trying to achieve through these ongoing efforts, and we are firmly committed to working with the SROs to ensure the success of these proposals. Many of the additional relationships that commenters requested the Commission include in the final rule are already restricted by existing SRO rules, or would be restricted under the new SRO proposals.
We continue to believe that our specific mandate under Section 10A(m) of the Exchange Act, where independence is evaluated by reference to payments of advisory and compensatory fees and affiliate status, is best fulfilled by the final rule. These requirements standing alone do not, for example, preclude independence on the basis of other commercial relationships not specified in the final rule, and they do not extend to the broad categories of family members that may be reached by SRO listing standards. Instead, as proposed, our requirements build and rely on SRO standards of independence that cover additional relationships not specified in Exchange Act Section 10A(m). Our final rule allows SROs flexibility to adopt and administer additional requirements of these sorts through SRO rulemaking conducted under Commission oversight and approval. As mentioned in the Proposing Release, we encourage SROs to review and adopt rigorous independence requirements in connection with their implementation of the standards in Exchange Act Rule 10A-3. We will review the rules submitted by the SROs to implement Exchange Act Rule 10A-3 so that they contain appropriate overall standards for audit committee independence.
2. Advising, Consulting or Compensatory Fees
As for the two criteria for independence in Exchange Act Rule 10A-3, the first is that audit committee members are barred from accepting any consulting, advisory or other compensatory fee from the issuer or any subsidiary thereof, other than in the member's capacity as a member of the board of directors and any board committee.45 This prohibition will preclude payments to a member as an officer or employee, as well as other compensatory payments.46
To prevent evasion of the requirement, disallowed payments to an audit committee member includes payments made either directly or indirectly. The overwhelming majority of commenters supported our determination that barring indirect as well as direct compensatory payments is necessary to implement the intended purposes of Exchange Act Section 10A(m).47 For example, payments to spouses of members raise questions regarding independence comparable to those raised by payments to members themselves. In addition, we believe that payments for services to law firms, accounting firms, consulting firms, investment banks or financial advisory firms in which audit committee members are partners, members, executive officers or hold similar positions, as discussed in more detail below, are the kinds of compensatory payments that were intended to be precluded by Exchange Act Section 10A(m). The final rules, therefore, mandate that indirect acceptance of compensatory payments includes payments to spouses, minor children or stepchildren or children or stepchildren sharing a home with the member. In addition, indirect acceptance includes payments accepted by an entity in which such member is a partner, member, officer such as a managing director occupying a comparable position or executive officer, or occupies a similar position (except limited partners, non-managing members and those occupying similar positions who, in each case, have no active role in providing services to the entity) and which provides accounting, consulting, legal, investment banking or financial advisory services to the issuer or any subsidiary.
Commenters generally supported the extent to which family members are included, although a few recommended an extension to additional members,48 and a few others recommended narrowing the family members covered.49 We continue to believe that an extension to all relatives is beyond the scope necessary to address the prohibitions in Section 10A(m), and we are adopting the family member formulation as proposed. Also, we agree with the commenters who argued that given the limited number of immediate family members affected, an exception for family members that are non-executive employees is not necessary.50
Several commenters requested additional guidance regarding the types of prohibited services in the "indirect" category.51 In particular, commenters were most concerned with the application of the prohibition to issuers or associated entities that provide financial services. To clarify application of the prohibition, the final rule specifies that the prohibition covers accounting, consulting, legal, investment banking or financial advisory services. Other commercial relationships are not covered by the final rule, although, as previously discussed, we expect that SROs will contain restrictions on additional services and activities in their own listing standards.52 For example, the prohibitions in Exchange Act Rule 10A-3 do not include non-advisory financial services such as lending, check clearing, maintaining customer accounts, stock brokerage services or custodial and cash management services. Further, the final rule relates only to requirements for audit committee membership. They do not affect the ability of a director associated with an entity that provides such services to a listed issuer from otherwise serving on that issuer's board of directors, again to the extent other SRO rules permit such relationships.
Several commenters requested clarification regarding the types of positions that are covered at associated entities.53 The Proposing Release would have applied the prohibition where the audit committee member was a partner, member or principal or occupied a similar position with the associated entity. Some commenters questioned whether the prohibition extended to solely passive ownership positions, such as limited partners in a limited partnership and non-managing members of a manager-managed limited liability company that have no active role in providing services to the entity. Some thought the term "principal" was vague outside of organizations that specifically use that term. Others noted that while the formulation correctly indicated the Commission's intention to capture all partners or limited liability company members of a law firm, accounting firm, consulting firm or other professional organization, it was not clear how the formulation was to be applied to entities that do not have or use the term partners or members, such as certain investment banking firms organized as corporations.
In response to these concerns, we have clarified that the list of covered positions includes partners and members (except for limited partners, non-managing members and those occupying similar positions who, in each case, have no active role in providing services to the entity), officers such as managing directors occupying a comparable position and executive officers (to address organizations that do not have partners and members) and others occupying a similar position. We believe extending the prohibition to any employee of an associated entity, as requested by some commenters, would be overly broad for purposes of Exchange Act Rule 10A-3, although SROs may require such an extension in their implementing rules.54 However, we do believe the formulation should include those persons, such as partners or members in professional organizations, regardless of control, whose compensation could be directly affected by the prohibited fees, even if they are not the primary service provider. Finally, we have deleted the term "principal" because we believe the reference to "those occupying similar positions" covers entities such as professional corporations that use the "principal" designation for positions similar to a partner in a partnership.
The final rule, like our proposal, applies the prohibitions only to current relationships with the audit committee member and related persons. They do not extend to a "look back" period before appointment to the audit committee, although we expect the SROs to require such periods in their own listing standards. Similar to the comments regarding including additional independence standards in the final rule, the majority of commenters supported our proposal, arguing it is consistent with the language in Exchange Act Section 10A(m) and the Commission's approach of building and relying on the SRO's independence standards that already include look back periods for a broad variety of relationships.55
In the Proposing Release, we requested comment on whether we should explicitly clarify whether the prohibition on "compensatory fees" excludes compensation under a retirement or similar plan in which a former officer or employee of the issuer participates. Many commenters supported such a clarification.56 We believe such a clarification is appropriate particularly given that the rules apply only to current relationships, especially where the retirement compensation received is for prior service and is not contingent in any way on continued service. Accordingly, the final rule specifies that, unless an SRO's listing rules provide otherwise, compensatory fees do not include the receipt of fixed amounts of compensation under a retirement plan (including deferred compensation) for prior service with the listed issuer (provided that such compensation is not contingent in any way on continued service).57
Exchange Act Section 10A(m) prohibits the receipt of "any" consulting, advisory or compensatory fees. While the Sarbanes-Oxley Act specifically included a de minimis exception with respect to other requirements, such as the audit committee pre-approval requirements in Exchange Act Section 10A(i)(1)(B),58 it provided no similar de minimis exception in Exchange Act Section 10A(m), even though several SROs currently have such exceptions in their listing standards. Consistent with the express language in Exchange Act Section 10A(m), our proposed rule did not contain a de minimis exception. Nevertheless, we requested comment on whether there should be such an exception. Several commenters, including those that represent investor groups, argued forcefully that no additional relationships should be exempted, including de minimis payments. They argued that the statutory mandate is clear, audit committee members should be truly independent, and even a de minimis level of payments would create the appearance of conflict.59 Several other commenters, primarily representing issuers and their advisors, supported some form of de minimis or immaterial exception, believing that issuers should have flexibility to pay some level of de minimis or immaterial fees to make the requirement less restrictive.60
We are not persuaded that such an exception is an appropriate deviation from the explicit mandate in Exchange Act Section 10A(m). We believe the policies and purposes behind that section, and particularly the use of the term "any" when describing such fees in the statute, weighs against providing for such an exception. Further, given the narrow class of services covered by the final rule, the lack of a de minimis exception should be less necessary. Moreover, if the level of compensation that the member or associated entity receives is truly de minimis and immaterial, we are not persuaded that requiring an issuer to locate another provider so that the member can remain qualified for audit committee service would be overly burdensome. In Section II.F.5, we provide a limited accommodation to address the concerns by some commenters regarding an audit committee member that ceases to be independent for reasons outside the member's reasonable control.
3. Affiliated Person of the Issuer or Any Subsidiary Thereof
Consistent with the express requirement in Exchange Act Section 10A(m)(3)(B)(ii), the second basic criterion for determining independence is that a member of the audit committee of an issuer that is not an investment company may not be an affiliated person of the issuer or any subsidiary of the issuer apart from his or her capacity as a member of the board and any board committee. Consistent with the Proposing Release, we are defining the terms "affiliate" and "affiliated person" consistent with our other definitions of these terms under the securities laws, such as in Exchange Act Rule 12b-261 and Securities Act Rule 144,62 with an additional safe harbor.63 We are defining "affiliate" of, or a person "affiliated" with, a specified person, to mean "a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the person specified."64 We are defining the term "control" consistent with our other definitions of this term under the Exchange Act65 as "the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise."66 Commenters generally supported this approach.67
Our definition of "affiliated person" for non-investment companies, like our existing definitions of this term for these issuers, requires a factual determination based on a consideration of all relevant facts and circumstances. To facilitate the analysis on facts and circumstances where we are presumptively comfortable, we are adopting a safe harbor for that aspect of the definition of "affiliated person," with minor modifications from the original proposal.68 Under the safe harbor as adopted, a person who is not an executive officer or a shareholder owning 10% or more of any class of voting equity securities of a specified person will be deemed not to control such specified person.69 Many commenters supported the safe harbor and the certainty it will provide to non-affiliates.70 We have clarified in the final rule, in response to several commenter suggestions, that the ownership prong should be based on ownership of any class of voting equity securities, instead of any class of equity securities.
The Proposing Release specified that those that cannot rely on the safe harbor would not be deemed to be or presumed to be affiliates. Those persons would need to conduct a facts and circumstances analysis of control. Nevertheless, some commenters and others reporting on the proposals were concerned that the 10% shareholder prong in the safe harbor somehow is, is implied to be, or would become viewed as an upper ownership limit for non-affiliate status.71 We have no intention of this being the case. While SROs in their listing rules could establish an upper ownership limit that would preclude independence, the safe harbor in Exchange Act Rule 10A-3 does not establish such a limit. The safe harbor is designed to identify a group of those that are not affiliates so as to provide comfort to those individuals or entities that no additional facts and circumstances analysis is necessary. It only creates a safe harbor position for non-affiliate status. Failing to meet the 10% ownership threshold has no bearing on whether a particular person is an affiliate based on an evaluation of all facts and circumstances. A director who is not an executive officer but beneficially owns more than 10% of the issuer's voting equity could be determined to be not an affiliate under a facts and circumstances analysis of control.
We continue to believe that a 10% ownership limit is an appropriate threshold to presume (along with the other aspects of the safe harbor) that a person is not an affiliate. Accordingly, we are not changing that threshold. However, the safe harbor does not in any way specify or imply that a certain level of share ownership automatically presumes that a person is an affiliate. To prevent further misconceptions, we have added an explicit paragraph to the final rule to reinforce these points.
We received several comments regarding how beneficial ownership is to be determined for purposes of the safe harbor, as well as for other aspects of the rule, such as the multiple listing exception. Accordingly, we have included an instruction to the final rule to clarify that calculations of beneficial ownership are to be made consistent with Exchange Act Rule 13d-3.72
The proposed rules would have deemed a director, executive officer, partner, member, principal or designee of an affiliate to be an affiliate. While some commenters expressed specific support for this formulation,73 several others believed the formulation was overly broad and would capture those who may not necessarily control the affiliate, such as outside directors of an affiliate.74 These commenters raised concerns similar to those raised regarding our proposal to include partners, members and principals in the compensatory fee prohibition. Many also were concerned that including the term "designee" could inadvertently mean that where there was a controlling shareholder, all directors that were elected, including those that met the independence requirements, could be considered "designees" of an affiliate and disqualified from service because the controlling shareholder had the power to elect all such directors.
After evaluating these comments, we are narrowing the formulation. Under the final rule, only executive officers, directors that are also employees of an affiliate, general partners and managing members of an affiliate will be deemed to be affiliates. The limitation on directors will exclude outside directors of an affiliate from the automatic designation. Also, the reference to executive officers, general partners and managing members of an affiliate includes the positions we intend to cover. This will help clarify that passive, non-control positions, such as limited partners, and those that do not have policy making functions, are not covered. The formulation for being deemed to be an affiliate is narrower than the formulation of covered positions for the indirect acceptance aspect of the "no compensation" prong due to their different purposes. We believe a wider formulation is necessary for the "no compensation" prong to capture those whose compensation is more directly linked to fees from the prohibited services but who otherwise do not hold executive positions. Finally, we have removed the term "designee." However, consistent with our historical interpretations of the term "affiliate," an affiliate could not evade the prohibitions in the rule simply by designating a third party representative or agent that it directs to act in its place.
For issuers that are investment companies, we are adopting, as proposed, the requirement that a member of the audit committee of an investment company may not be an "interested person" of the investment company, as defined in Section 2(a)(19)75 of the Investment Company Act.76 As described in the Proposing Release, we have substituted the Section 2(a)(19) test for the affiliation test applied to operating companies because the Section 2(a)(19) test is tailored to capture the broad range of affiliations with investment advisers, principal underwriters, and others that are relevant to "independence" in the case of investment companies. Commenters supported this substitution.77
4. New Issuers
Under Exchange Act Section 10A(m)(3)(C), we have the authority to exempt from the independence requirements particular relationships with respect to audit committee members, if appropriate in light of the circumstances. As discussed in the Proposing Release, companies coming to market for the first time may face particular difficulty in recruiting members that meet the independence requirements. Before completion of a company's initial public offering, the board of directors often will consist primarily, if not exclusively, of representatives of venture capital investors and insiders. Such representation is entirely consistent with the desire of these parties to have representation in their private venture. The difficulty of recruiting independent directors before an initial public offering, coupled with the uncertainty of whether the initial public offering will be completed, may discourage companies from accessing the public markets to grow their business and provide liquidity, as well as from achieving the other benefits of being a public company, if all of their audit committee members must be independent at the time of the initial public offering. Further, the audit committee of some new public companies may function more effectively if it can maintain historical knowledge and experience during the transition to public company status.
As a result, we proposed an exemption for one member of a non-investment company issuer's audit committee from the independence requirements for 90 days from the effective date of an issuer's initial registration statement under Section 12 of the Exchange Act or a registration statement under the Securities Act covering an initial public offering of securities of the issuer. We requested comment on whether this exemption should be extended. While not all agreed,78 the overwhelming majority of commenters believed the proposed exemption was too restrictive to address the potential problems new issuers may face.79 Particularly given the increased focus on board service in general, and audit committee service in particular, commenters argued that additional accommodations in both the length of the exemption and the number of members covered are necessary to not overly burden access to the capital markets.
While we recognize these potential difficulties, we continue to believe that it is important to have at least some independent representation on the audit committee at the time of an initial listing, and that a majority of the committee and the full committee should reach the independence requirements as soon as practicable. Accordingly, to balance the concerns between the need for independence and the ability to recruit qualified candidates, we are adopting a revised exception for non-investment company issuers that requires at least one fully independent member at the time of an issuer's initial listing, a majority of independent members within 90 days, and a fully independent committee within one year.
5. Overlapping Board Relationships
As discussed in the Proposing Release, many companies, particularly financial institutions and other entities with a holding company structure, operate or obtain financing through subsidiaries. For these companies, the composition of the boards of the parent company and the subsidiary are sometimes similar given the control structure between the parent and the subsidiary. If an audit committee member of the parent is otherwise independent, merely serving also on the board of a controlled subsidiary should not adversely affect the board member's independence, assuming that the board member also would be considered independent of the subsidiary except for the member's seat on the parent's board. Accordingly, we proposed an exemption from the "affiliated person" requirement for a committee member that sits on the board of directors of both a parent and a direct or indirect consolidated majority-owned subsidiary, if the committee member otherwise meets the independence requirements for both the parent and the subsidiary, including the receipt of only ordinary-course compensation for serving as a member of the board of directors, audit committee or any other board committee of the parent or subsidiary.
Commenters were nearly unanimous in their support for such an exemption.80 However, many commenters believed the exemption, particularly the requirement that the subsidiary must be both consolidated and majority-owned, was overly restrictive.81 Some companies may possess the requisite ownership to establish control, but may not consolidate the subsidiary due to particular accounting situations.82 Others may have the requisite control to consolidate by means other than ownership and therefore may not meet the ownership test. Several commenters were particularly concerned regarding unconsolidated 50% owned joint ventures, arguing that many of the reasons provided by the Commission for the exemption apply as well to such joint ventures where two parents exercise joint control.83 Other commenters noted that while the Commission's proposal addresses parents and subsidiaries, it did not provide similar accommodations for independent directors that serve on boards of sibling subsidiaries under common control of a parent, if such directors would be independent other than for the fact that the two sibling subsidiaries are affiliated through the parent.
To address these concerns, we are expanding the exemption. Under the final rule, an audit committee member may sit on the board of directors of a listed issuer and any affiliate so long as, except for being a director on each such board of directors, the member otherwise meets the independence requirements for each such entity, including the receipt of only ordinary-course compensation for serving as a member of the board of directors, audit committee or any other board committee of each such entity. Under the revised exemption, audit committee members will still be required to be independent of the issuer and its affiliate, but the exemption will now apply regardless of the source of control.
There are some foreign private issuers that operate under a dual holding company structure.84 Each holding company is a foreign private issuer organized in a different national jurisdiction. The holding companies together collectively own and supervise the management of one or more businesses conducted as a single economic enterprise. The holding companies do not conduct any business other than collectively owning and supervising such businesses. The boards of directors of these dual holding companies may have all, some or no members in common. The dual holding companies may have established a joint audit committee for the group consisting of directors from each dual holding company. The audit committee members of such entities would otherwise meet the independence requirements for the overall group, but could technically be considered affiliates, or as persons who are not directors, because of the particular structural form of the dual holding companies. We are providing an accommodation for such dual holding companies. First, where a listed issuer is one of two dual holding companies, those companies may designate one audit committee for both companies so long as each member of the audit committee is a member of the board of directors of at least one of such dual holding companies. Second, dual holding companies will not be deemed to be affiliates of each other by virtue of their dual holding company arrangements with each other, including where directors of one dual holding company are also directors of the other dual holding company, or where directors of one or both dual holding companies are also directors of the businesses jointly controlled, directly or indirectly, by the dual holding companies (and in each case receive only ordinary-course compensation for serving as a member of the board of directors, audit committee or any other board committee of the dual holding companies or any entity that is jointly controlled, directly or indirectly, by the dual holding companies).
6. Other Requests for Independence Exemptions
As discussed in Section II.G.1 below, issuers availing themselves of exemptions from Exchange Act Rule 10A-3 will generally have to disclose that fact. Apart from the two limited exemptions discussed in Sections II.B.4 and 5 above and the exemptions for controlling persons, foreign governmental board representatives and non-management employee members of foreign private issuers discussed in Section II.F.3.a below, we are not exempting other particular relationships from the independence requirements at this time.
We noted in the Proposing Release that despite the existence of exemptions based on exceptional and limited circumstances in several existing SRO rules,85 Section 10A(m) of the Exchange Act, as enacted by Congress, does not contain any such exemption. Nevertheless, we requested comment as to whether such an exemption would be appropriate. Commenters were split on this point, with the commenters representing investors and investor groups not supporting such an exemption, and the commenters predominantly representing SROs supporting the freedom to provide such exemptions.86 Some of the commenters that advocated against the exemption were concerned that the existing SRO exceptions have been or could be applied in practice more broadly than intended, though some commenters supporting such an exemption disputed this point. Consistent with our proposal, our final rules do not contain any exemptions based on exceptional and limited circumstances.
We also announced in the Proposing Release that, given the policy and purposes behind the Sarbanes-Oxley Act, as well as to maintain consistency and to ease administration of the requirements by the SROs, we do not intend to entertain exemptions or waivers for particular relationships on a case-by-case basis.87 We requested comment on whether we should permit companies to request exemptive relief from the Commission or SROs on a case-by-case basis. Commenters also were split on this point, again with the commenters representing predominantly investors and investor groups not supporting case-by-case relief.88 After carefully considering these comments, we still believe that general case-by-case exemptions would be neither appropriate nor consistent with the policies and purposes of the Sarbanes-Oxley Act. However, as requested by many commenters,89 the Commission has exemptive authority to respond to, and will remain sensitive to, evolving standards of corporate governance, including changes in U.S. or foreign law, to address any new conflicts that cannot be anticipated at this time.
B. Responsibilities Relating to Registered Public Accounting Firms
1. Scope of the Requirement
One of the audit committee's primary functions is to enhance the independence of the audit function, thereby furthering the objectivity of financial reporting. The Commission has long recognized the importance of an auditor's independence in the audit process.90 The auditing process may be compromised when a company's outside auditors view their main responsibility as serving the company's management rather than its full board of directors or its audit committee. This may occur if the auditor views management as its employer with hiring, firing and compensatory powers. Under these conditions, the auditor may not have the appropriate incentive to raise concerns and conduct an objective review. Further, if the auditor does not appear independent to the public, then investor confidence is undermined and one purpose of the audit is frustrated. One way to help promote auditor independence, then, is for the auditor to be hired, evaluated and, if necessary, terminated by the audit committee. This would help to align the auditor's interests with those of shareholders.
Accordingly, we are adopting as proposed the requirement that the audit committee of a listed issuer will need to be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm engaged (including resolution of disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the issuer, and the independent auditor will have to report directly to the audit committee.91 These oversight responsibilities include the authority to retain the outside auditor, which includes the power not to retain (or to terminate) the outside auditor. In addition, in connection with these oversight responsibilities, the audit committee must have ultimate authority to approve all audit engagement fees and terms.92
Overall, commenters supported the requirement as proposed, believing additional specificity is not needed and flexibility should be given to the audit committee regarding the execution of these responsibilities, without rigid rules.93 A few commenters, however, suggested that we should limit the requirement to cover only certain registered public accounting firms that perform audit, review or attest services for the issuer, that we should limit the coverage of services specified by the proposal, or that we should clearly delineate which oversight responsibilities remain with management.94 We believe these specific decisions regarding the execution of the audit committee's oversight responsibilities, as well as decisions regarding the extent of desired involvement by the audit committee, are best left to the discretion of the audit committee of the individual issuer in assessing the issuer's individual circumstances. Accordingly, we are not limiting the oversight responsibilities provided by the statute and the proposal.
Some commenters requested further clarification regarding the scope of the services included in the requirement, including "audit, review or attest services." We believe these services encompass the same services covered in the "Audit Fees" category in an issuer's disclosure of fees paid to its independent public accountants. As discussed in our recent release revising the Commission's auditor independence requirements,95 this category includes services that normally would be provided by the accountant in connection with statutory and regulatory filings or engagements. In addition to services necessary to perform an audit or review in accordance with Generally Accepted Auditing Standards ("GAAS"),96 this category also may include services that generally only the independent accountant reasonably can provide, such as comfort letters, statutory audits, attest services, consents and assistance with and review of documents filed with the Commission. This approach does not affect the operation of other Commission rules regarding permissible services or preclude the audit committee from oversight or other involvement in the provision of audit-related or other permissible services.
In the Proposing Release, we requested comment on whether other responsibilities not listed in Exchange Act Section 10A(m) should be under the supervision of the audit committee, such as the appointment, compensation, retention and oversight of an issuer's internal auditor. Commenters were split on whether the Commission should mandate oversight responsibility regarding an issuer's internal auditor, with the majority not supporting action by the Commission at this time.97 Given this split, we are not extending the responsibility requirement to include such oversight.
2. Clarifications Regarding Possible Conflicts With Other Requirements
We proposed adding an instruction to the rule to clarify that the requirements regarding auditor responsibility do not conflict with, and are not affected by, any requirement under an issuer's governing law or documents or other home country requirements that requires shareholders to elect, approve or ratify the selection of the issuer's auditor. The requirements instead relate to the assignment of responsibility to oversee the auditor's work as between the audit committee and management. Commenters welcomed this clarification.98 However, several commenters recommended extending the instruction to include other requirements in the rule, such as auditor compensation and termination, to address foreign requirements that vest these responsibilities with shareholders.99 We agree with these commenters that the same reasons that justify the clarification regarding auditor selection justify an extension to these other responsibilities. We also agree with those commenters that noted that the clarification should apply even if shareholders are not required to vote on the responsibilities, but voluntarily elect to do so.100
Accordingly, we are expanding the instruction. The revised instruction clarifies that none of the audit committee requirements in the final rule conflicts with, nor do they affect the application of, any requirement or ability under an issuer's governing law or documents or other home country legal or listing provisions that requires or permits shareholders to ultimately vote on, approve or ratify such requirements. In addition, we are adopting as proposed the further clarification that if such responsibilities are vested with shareholders, and the issuer provides a recommendation or nomination regarding such matters to its shareholders, the audit committee of the issuer, or body performing similar functions, must be responsible for making the recommendation or nomination.
The proposed instruction also included a clarification that the requirement that the audit committee select auditors does not conflict with any requirement in a company's home jurisdiction that prohibits the full board of directors from delegating such responsibility to a committee. In that case, the audit committee would need to be granted advisory and other powers with respect to such matters to the extent permitted by law, including submitting nominations or proposals to the full board. Several commenters noted that this instruction should be expanded to address other responsibilities in the final rule for the same reasons as those relating to shareholder approval.101 In some jurisdictions, boards may be prohibited from delegating such responsibilities to a committee, including the ability to submit nominations or recommendations to shareholders as called for in the instruction regarding shareholder approval of such matters.
Accordingly, we are expanding the instruction to cover other situations where the board of directors may be prohibited from delegating responsibility to the audit committee, including the ability to submit nominations or recommendations to shareholders. The revised instruction clarifies that none of the audit committee requirements in the final rule, including the requirement that the audit committee provide recommendations to shareholders where such responsibilities are vested with shareholders, conflicts with any legal or listing requirement in an issuer's home jurisdiction that prohibits the full board of directors from delegating such responsibilities to the audit committee or limits the degree of such delegation. However, we continue to believe that in such an instance, the audit committee, or body performing similar functions, must be granted such responsibilities, which can include advisory powers, with respect to such matters to the extent permitted by law, including submitting nominations or recommendations to the full board of directors.
Finally, some commenters noted that in some jurisdictions, the outside auditor can only be removed by court order upon specified circumstances.102 Other commenters noted that the government is required to select the outside auditor for some foreign private issuers. Similar to the previous instructions, we are providing an additional instruction to clarify that the requirements in the final rule do not conflict with any legal or listing requirement in an issuer's home jurisdiction vesting such responsibilities with a government entity or tribunal. Similar to the other instructions, in such an instance we believe the audit committee should be granted such responsibilities, which can include advisory powers, with respect to such matters to the extent permitted by law.
Some commenters requested that we provide for these clarifications as explicit exemptions from the final rule. As noted previously, however, we believe that the rule's requirements relate to the assignment of such responsibilities as between the audit committee and management. They do not conflict with, and otherwise have no bearing on, the vesting of such responsibilities in other bodies such as shareholders or government entities. Accordingly, we believe it is more appropriate to clarify what the requirements do not apply to or conflict with in the form of an instruction rather than an exemption.
3. Application to Investment Companies
We proposed to exempt investment companies from the requirement that the audit committee be responsible for the selection of the independent auditor. We proposed the exemption in light of Section 32(a) of the Investment Company Act,103 which requires that independent auditors of registered investment companies be selected by majority vote of the disinterested directors.104
On January 28, 2003, we adopted amendments to our existing requirements regarding auditor independence.105 Those amendments require that the audit committee of a registered investment company pre-approve all audit, review, or attest engagements required under the securities laws, a requirement that was supported by the commenters.106 In order to conform the rules that we are adopting today to the auditor independence rules, we are removing the proposed exemption for investment companies from the requirements regarding selection of the auditor. As a result, the audit committee will be required to select the independent auditor and, under Section 32(a) of the Investment Company Act, the independent directors will be required to ratify the selection.
C. Procedures for Handling Complaints
The audit committee must place some reliance on management for information about the company's financial reporting process. Since the audit committee is dependent to a degree on the information provided to it by management and internal and outside auditors, it is imperative for the committee to cultivate open and effective channels of information. Management may not have the appropriate incentives to self-report all questionable practices. A company employee or other individual may be reticent to report concerns regarding questionable accounting or other matters for fear of management reprisal.107 The establishment of formal procedures for receiving and handling complaints should serve to facilitate disclosures, encourage proper individual conduct and alert the audit committee to potential problems before they have serious consequences.
Accordingly, under the listing standards called for by our final rules, each audit committee must establish procedures for:108
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The receipt, retention and treatment of complaints received by the issuer regarding accounting, internal accounting controls or auditing matters, and
The confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters.
As proposed, we are not mandating specific procedures that the audit committee must establish. Commenters were split over whether specific procedures should be mandated. The minority, representing primarily consultants and other third-party providers of such services, as well as several commenters representing investors, believed the Commission should mandate specific procedures, and many advocated a national "one-size-fits-all" approach.109 A substantial number of commenters, however, supported the Commission's approach of not mandating specific procedures, instead preferring to leave flexibility to the audit committee to develop appropriate procedures in light of a company's individual circumstances, so long as the required parameters are met.110
Given the variety of listed issuers in the U.S. capital markets, we believe audit committees should be provided with flexibility to develop and utilize procedures appropriate for their circumstances. The procedures that will be most effective to meet the requirements for a very small listed issuer with few employees could be very different from the processes and systems that would need to be in place for large, multi-national corporations with thousands of employees in many different jurisdictions. We do not believe that in this instance a "one-size-fits-all" approach would be appropriate. As noted in the Proposing Release, we expect each audit committee to develop procedures that work best consistent with its company's individual circumstances to meet the requirements in the final rule. Similarly, we are not adopting the suggestion of a few commenters that, despite the statutory language, the requirement should be limited to only employees in the financial reporting area.111
While the scope of the requirements generally includes complaints received by a listed issuer regardless of source, Exchange Act Section 10A(m)(4)(B) and the relevant portion of the rules referring to confidential, anonymous submission of concerns are directed to employees of the issuer. One commenter noted that investment companies rarely have direct employees.112 The commenter suggested that, for investment companies, the confidential, anonymous submission requirements should extend to employees of entities engaged by an investment company to prepare or assist in preparing its financial statements. We encourage the SROs to consider the appropriate scope of the requirement with regard to investment companies, taking account of the fact that most services are rendered to an investment company by employees of third parties, such as the investment adviser, rather than by employees of the investment company.113
D. Authority to Engage Advisors
To be effective, an audit committee must have the necessary resources and authority to fulfill its function. The audit committee likely is not equipped to self-advise on all accounting, financial reporting or legal matters. To perform its role effectively, therefore, an audit committee may need the authority to engage its own outside advisors, including experts in particular areas of accounting, as it determines necessary apart from counsel or advisors hired by management, especially when potential conflicts of interest with management may be apparent.
The advice of outside advisors may be necessary to identify potential conflicts of interest and assess the company's disclosure and other compliance obligations with an independent and critical eye. Often, outside advisors can draw on their experience and knowledge to identify best practices of other companies that might be appropriate for the issuer. The assistance of outside advisors also may be needed to independently investigate questions that may arise regarding financial reporting and compliance with the securities laws. Accordingly, as proposed, the final rule specifically requires an issuer's audit committee to have the authority to engage outside advisors, including counsel, as it determines necessary to carry out its duties.114 Commenters supported this requirement as proposed.115
E. Funding
An audit committee's effectiveness may be compromised if it is dependent on management's discretion to compensate the independent auditor or the advisors employed by the committee, especially when potential conflicts of interest with management may be apparent. Accordingly, as proposed, the final rule requires the issuer to provide for appropriate funding, as determined by the audit committee, in its capacity as a committee of the board of directors, for payment of compensation:
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To any registered public accounting firm engaged for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the listed issuer;116 and
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To any advisors employed by the audit committee.
This requirement will further the standard relating to the audit committee's responsibility to appoint, compensate, retain and oversee the outside auditor. It also will add meaning to the standard relating to the audit committee's authority to engage independent advisors. Not only could an audit committee be hindered in its ability to perform its duties objectively by not having control over the ability to compensate these advisors, but the role of the advisors also could be compromised if they are required to rely on management for compensation. Thus, absent such a provision, both the audit committee and the advisors could be less willing to address disagreements or other issues with management.
Commenters supported this requirement.117 We also requested comment on whether there should be limits on the amount of compensation that could be requested by the audit committee. The overwhelming majority of commenters did not support compensation limits, arguing that to do otherwise would subvert the intent of the requirement.118 These commenters argued that audit committee members' own fiduciary duties to the issuer and natural oversight by the board of directors as a whole over the audit committee would address any concerns over abuse. The final rule does not set funding limits.
Some commenters believed it would be appropriate to supplement the funding requirements.119 While the Commission's proposal would address the compensation of advisors, it would not provide assurance that the audit committee itself can obtain the funding it needs to carry out its duties. Specifically, these commenters believed the final rule should also state that the issuer must provide appropriate funding for ordinary administrative expenses of the audit committee. We find merit in this suggestion. An audit committee's effectiveness may be compromised if it is dependent on management's discretion to pay for the committee's expenses, especially when potential conflicts of interest with management may be apparent. Accordingly, the final rule provides that, in addition to funding for advisors, the issuer must provide appropriate funding for ordinary administrative expenses of the audit committee that are necessary or appropriate in carrying out its duties.
F. Application and Implementation of the Standards
1. SROs Affected and Implementation Dates
Section 10A(m) of the Exchange Act by its terms applies to all national securities exchanges and national securities associations. These entities, to the extent that their listing standards do not already comply with the final rule, will be required to issue or modify their rules, subject to Commission review, to conform their listing standards.120 The SROs are not precluded from adopting additional listing standards regarding audit committees, as long as they are consistent with Exchange Act Rule 10A-3.
To facilitate timely implementation of the requirements, we proposed compliance dates by when each SRO must provide to the Commission proposed rules and rule amendments to implement Exchange Act Rule 10A-3, as well as by when such rules or rule amendments must be approved by the Commission. As proposed, SROs would have had until 60 days after publication of our final rule in the Federal Register to provide proposed rules or rule amendments, and until 270 days after publication of our final rule to have such rules or rule amendments approved by the Commission. Commenters generally supported these compliance dates, although several requested additional time to submit the proposed rules and rule amendments.121
In response to these comments, the SRO compliance dates we are adopting in the final rule are designed to facilitate timely implementation of the new requirements, while providing additional time for SROs to submit proposed rules or rule amendments. Under the final rule, each SRO must provide to the Commission proposed rules or rule amendments that comply with the requirements no later than July 15, 2003. Final rules or rule amendments must be approved by the Commission no later than December 1, 2003.
Regarding when listed issuers must be in compliance with the new listing rules, we proposed that the new requirements would need to be operative by the SROs no later than the first anniversary of the publication of our final rule in the Federal Register. A few commenters believed the proposed implementation dates were adequate for issuers to make the necessary changes to their audit committees, arguing that timely implementation is key to restoring investor confidence and public trust.122 However, a substantial group of commenters recommended modifications and additional time for issuers to comply, for three primary reasons.
First, commenters noted that the new requirements as proposed would become operative during the 2004 annual shareholder meeting period for most listed issuers.123 Given the importance of allowing issuers to identify, evaluate and recruit qualified directors, as well as the desirability of avoiding the burden and expense of requiring special shareholder meetings to elect those directors, commenters requested the ability to coordinate compliance with their annual shareholder meeting schedule, such as the first annual shareholders meeting after approval of the SRO implementing rules, which could occur after the original compliance date proposed by the Commission.
Second, several commenters requested additional time for compliance by foreign private issuers.124 The new SRO rules may represent the first time that some foreign listed issuers will be subject to such requirements. Some were concerned that the pool of candidates available in some countries that would be qualified to perform the functions required of audit committee members may be limited. As such, it may take additional time to locate and attract qualified directors.
Finally, several commenters requested accommodations for smaller listed issuers.125 These issuers may need additional time to locate a sufficient number of qualified directors to meet the requirements. In addition, small business issuers that are listed on some markets, such as Nasdaq, have previously been exempt from listing requirements that require independence for the entire audit committee.126 Commenters requested an additional transition period for such companies to alleviate the potential burdens they may face.
In response to these concerns, we are adopting a revised set of implementation dates, with an extended date for foreign private issuers and smaller issuers. We are distinguishing listed issuers that are not foreign private issuers by size based upon whether they are a "small business issuer," as defined in Exchange Act Rule 12b-2. A small business issuer is a U.S. or Canadian issuer with less than $25 million in revenues and public float that is not an investment company.127
Under the final rule, listed issuers, other than foreign private issuers and small business issuers, must be in compliance with the new listing rules by the earlier of (1) their first annual shareholders meeting after January 15, 2004, or (2) October 31, 2004. Foreign private issuers and small business issuers must be in compliance with the new listing rules by July 31, 2005. We believe these dates strike an appropriate balance between the need for timely implementation of the requirements and the ability of listed issuers to comply with the requirements without an unreasonable burden.
As discussed in the Proposing Release, the OTC Bulletin Board (OTCBB), the Pink Sheets and the Yellow Sheets are not affected by Exchange Act Rule 10A-3, and therefore issuers whose securities are quoted on these interdealer quotation systems similarly will not be affected, unless their securities also are listed on an exchange or Nasdaq.128 Each of these quotation systems does not provide issuers with the ability to list their securities, but is a quotation medium for the over-the-counter securities market that collects and distributes market maker quotes to subscribers. These interdealer quotation systems do not maintain or impose listing standards, nor do they have a listing agreement or arrangement with the issuers whose securities are quoted through them. Although market makers may be required to review and maintain specified information about the issuer and to furnish that information to the interdealer quotation system,129 the issuers whose securities are quoted on such systems do not have any filing or reporting requirements with the system.130
2. Securities Affected
In enacting Section 10A(m) of the Exchange Act, Congress made no distinction regarding the type of securities to be covered. Section 10A(m)(1)(A) of the Exchange Act prohibits the listing of "any security" of an issuer that does not meet the new standards for audit committees. Accordingly, the final rule applies not just to voting equity securities, but to any listed security, regardless of its type, including debt securities, derivative securities and other types of listed securities. We believe investors in all securities of an issuer, whether common equity or fixed income, will benefit from the increased financial oversight of an issuer that would result from a strong and effective audit committee.
Despite the statutory language, a few commenters believed that debt securities and non-convertible preferred securities should be exempted in their entirety.131 As discussed above, we do not believe such a broad-based exemption is consistent with the language and the intent of Section 10A(m). Effective oversight of financial reporting improves the quality and accuracy of such reporting. Quality and accurate financial reporting facilitates the proper pricing and liquidity of all securities on listed markets, regardless of type. While the Sarbanes-Oxley Act made explicit distinctions between debt and equity securities in several different provisions,132 it made no such distinction in enacting Exchange Act Section 10A(m). To avoid undue burden on listed issuers, including debt issuers, we have adopted several exemptions where consistent with the purposes and policies of Section 10A(m) and the protection of investors, such as the overlapping board exemption discussed in Section II.A.5 and the multiple listing exemption discussed below.
a. Multiple Listings
Many companies today issue multiple classes of securities through various ownership structures on various markets. For example, a company may have a class of common equity securities listed on one market, several classes of debt listed on one or more other markets, and derivative securities listed on yet another market. If an issuer already was subject to the requirements in Exchange Act Rule 10A-3 as a result of one listing, there would be little or no additional benefit from having the requirements imposed on the issuer due to an additional listing.
In addition, companies often issue non-equity securities through controlled subsidiaries for various reasons. Requiring these subsidiaries, which often have no purpose other than to issue or guarantee the securities, to be subject to the audit committee requirements would add little additional benefit if the subsidiary is closely controlled or consolidated by a parent issuer that is subject to the requirements. Instead, imposing the requirements on these subsidiaries could create an onerous burden on the parent to recruit and maintain an audit committee meeting the requirements for each specific subsidiary.
Accordingly, we are adopting as proposed an exemption from the requirements for listings of additional classes of securities of an issuer at any time the issuer is subject to the requirements as a result of the listing of a class of common equity or similar securities. The additional listings could be on the same market or on different markets. Some commenters questioned conditioning the exemption on the listing of a class of common equity or similar securities.133 We proposed conditioning this exemption on the listing of a class of common equity or similar securities because these securities will most likely represent the primary public listing of the company and the applicable listing standards, including those required by our rules, would be likely to be the most comprehensive. We are persuaded that this approach is proper in respect of the listing of subsidiaries' securities, but it is not necessary in the case of multiple listings of the issuer itself. Therefore, the exemption for additional classes of a listed issuer will apply if any class of securities of the issuer is listed on a national securities exchange or national securities association subject to these rules.
Of course, just as an SRO may adopt standards for audit committees that are stricter than those provided in Exchange Act Rule 10A-3, they also may apply their listing standards, including those implementing Exchange Act Rule 10A-3, to classes of securities where Exchange Act Rule 10A-3 would not require it. For example, in the case of an issuer with a class of debt securities listed on an SRO subject to these rules, another SRO may condition listing by that issuer of its common equity securities on full compliance with that second SRO's listing standards regarding the requirements in Exchange Act Rule 10A-3. Moreover, our rules do not embody a "first in time" principle, so that in the above example, once the class of common equity securities was listed on the second SRO subject to our requirements, unless SRO rules provide otherwise, the multiple listing exemption could be applied in respect of the debt securities listed on the first SRO.
Also as proposed, we are extending the exemption to listings of non-equity securities by certain additional subsidiaries of a parent company, if the parent company is subject to the requirements as a result of the listing of a class of equity securities. We proposed having the exemption apply to non-equity listings by direct or indirect consolidated majority-owned subsidiaries of a parent company. While commenters uniformly supported the exemption,134 some believed that, for many of the same reasons discussed above regarding the independence exemption for overlapping boards of directors, the number of subsidiaries that would be covered by the multiple listing exemption was too restrictive.135
In this instance, however, we believe that a greater degree of interest between the parent and the subsidiary is important. The multiple listing exemption will mean that, unless an SRO's rules provide otherwise, a publicly traded entity will not need to have any independent audit committee members or otherwise be subject to the audit committee responsibilities in Exchange Act Rule 10A-3. It is more important in this instance to ensure that the parent company's audit committee is in the appropriate position to provide oversight for the financial reporting of the subsidiary. This is most likely to be the case if the parent consolidates the subsidiary into its own financial statements. Nevertheless, we also understand that a parent may possess the requisite ownership threshold, but may not consolidate the subsidiary due to particular accounting situations.136 Similarly, 50% owned joint ventures may not be consolidated by the two parents that exercise joint control.137
To address these concerns, we are expanding the exemption from the proposal to include listings of non-equity securities by a direct or indirect subsidiary that is consolidated or at least 50% beneficially owned by a parent company, if the parent company is subject to the requirements as a result of the listing of a class of its equity securities. However, as proposed, if the subsidiary were to list its own equity securities (other than non-convertible, non-participating preferred securities138), the subsidiary will be required to meet the requirements to protect its own public shareholders. The multiple listing exemption is available to U.S. subsidiaries if the parent is a foreign private issuer, even if the foreign parent is relying on one of the special exemptions for foreign private issuers (such as the board of auditors exemption). However, the special exemptions available to the foreign parent are of course not available to its U.S. subsidiary.
b. Security Futures Products and Standardized Options
The enactment of the Commodity Futures Modernization Act of 2000, or CFMA,139 addressed the regulation of security futures products.140 It permits national securities exchanges registered under Section 6 of the Exchange Act141 and national securities associations registered under Section 15A(a) of the Exchange Act142 to trade futures on individual securities and on narrow-based security indices ("security futures") without being subject to the issuer registration requirements of the Securities Act and Exchange Act as long as they are cleared by a clearing agency that is registered under Section 17A of the Exchange Act143 or that is exempt from registration under Section 17A(b)(7)(A) of the Exchange Act. In December 2002, we adopted rules to provide comparable regulatory treatment for standardized options.144
The role of the clearing agency for security futures products and standardized options is fundamentally different from a conventional issuer of securities. For example, the purchaser of these products does not, except in the most formal sense, make an investment decision regarding the clearing agency. As a result, information about the clearing agency's business, its officers and directors and its financial statements is less relevant to investors in these products than to investors in the underlying security. Similarly, the investment risk in these products is determined by the market performance of the underlying security rather than the performance of the clearing agency. Moreover, the clearing agencies are self-regulatory organizations subject to regulatory oversight. Furthermore, unlike a conventional issuer, the clearing agency does not receive the proceeds from sales of security futures products or standardized options.145
Recognizing these fundamental differences, we are adopting as proposed an exemption for the listing of a security futures product cleared by a clearing agency that is registered under Section 17A of the Exchange Act or exempt from registration under Section 17A(b)(7) of the Exchange Act. We are adopting as proposed a similar exemption for the listing of standardized options issued by a clearing agency registered under Section 17A of the Exchange Act.
3. Issuers Affected
a. Foreign Issuers
As discussed in the Proposing Release, U.S. investors increasingly have been seeking opportunities to invest in a wide range of securities, including the securities of foreign issuers, and foreign issuers have been seeking opportunities to raise capital and effect equity-based acquisitions in the U.S. using their securities as the "acquisition currency." The Commission has responded to these trends by seeking to facilitate the ability of foreign issuers to access U.S. investors through listings and offerings in the U.S. capital markets. We have long recognized the importance of the globalization of the securities markets both for investors who desire increased diversification and international companies that seek capital in new markets.
Section 10A(m) of the Exchange Act makes no distinction between domestic and foreign issuers. With the growing globalization of the capital markets, the importance of maintaining effective oversight over the financial reporting process is relevant for listed securities of any issuer, regardless of its domicile. Many foreign private issuers already maintain audit committees, and the global trend appears to be toward establishing audit committees.146 Thus, as proposed, the Commission's direction to the SROs will apply to listings by foreign private issuers as well as domestic issuers.
However, as discussed in the Proposing Release, we are aware that the requirements may conflict with legal requirements, corporate governance standards and the methods for providing auditor oversight in the home jurisdictions of some foreign issuers. Even before we published the Proposing Release, several foreign issuers and their representatives had expressed concerns about the possible application of Exchange Act Section 10A(m).147 The Proposing Release prompted many thoughtful comments from dozens of foreign private issuers and their representatives from around the world. These commenters expressed overwhelming support for the Commission's approach of providing tailored exemptions and guidance where the requirements of Exchange Act Section 10A(m) could result in a direct conflict with home country requirements. In our final rules, we have attempted to address commenters' concerns regarding the specific areas in which foreign corporate governance arrangements differ significantly from general practices among U.S. corporations. In addition to the clarifications discussed in Section II.B., we discuss these matters below.
i. Employee Representation
We understand that some countries, such as Germany, require that non-management employees, who would not be viewed as "independent" under the requirements, serve on the supervisory board or audit committee.148 Having such employees serve on the board or audit committee can provide an independent check on management, which itself is one of the purposes of the independence requirements under the Sarbanes-Oxley Act. Accordingly, we are adopting as proposed a limited exemption from the independence requirements to address this concern, so long as the employees are not executive officers, as defined by Exchange Act Rule 3b-7.149
Commenters expressed support for this exemption.150 Some commenters, however, recommended extending the exemption to include also non-executive employees that serve on the supervisory board or audit committee as a result of an issuer's governing law or documents or an employee collective bargaining or similar agreement. Under the final rule, non-executive employees can sit on the audit committee of a foreign private issuer if the employee is elected or named to the board of directors or audit committee of the foreign private issuer pursuant to the issuer's governing law or documents, an employee collective bargaining or similar agreement or other home country legal or listing requirements.
ii. Two-Tier Board Systems
Some foreign private issuers have a two-tier board system, with one tier designated as the management board and the other tier designated as the supervisory or non-management board. In this circumstance, we believe that the supervisory or non-management board is the body within the company best equipped to comply with the requirements. Our final rule clarifies that in the case of foreign private issuers with two-tier board systems, the term "board of directors" means the supervisory or non-management board for purposes of Exchange Act Rule 10A-3. As such, the supervisory or non-management board can either form a separate audit committee or, if the entire supervisory or non-management board is independent within the provisions and exceptions of the rule, the entire board can be designated as the audit committee.151 Commenters supported this clarification.152
iii. Controlling Shareholder Representation
Controlling shareholders or shareholder groups are more prevalent among foreign issuers than in the U.S., and those controlling shareholders have traditionally played a more prominent role in corporate governance. In jurisdictions providing for audit committees, representation of controlling shareholders on these committees is common. As proposed, we believe that a limited exception from the independence requirements can accommodate this practice without undercutting the fundamental purposes of the rule. We proposed that one member of the audit committee can be a shareholder, or representative of a shareholder or group, owning more than 50% of the voting securities of a foreign private issuer, if the "no compensation" prong of the independence requirements is satisfied, the member in question has only observer status on, and is not a voting member or the chair of, the audit committee, and the member in question is not an executive officer of the issuer.
Several commenters requested that the exemption be extended. Some believed the 50% ownership threshold was too high, arguing that a shareholder can exercise control through lower levels of ownership or through non-ownership means.153 Others requested the ability to have more than one representative if there is more than one controlling shareholder.154 A few objected to the observer-only status provided by the proposed exemption.155
In response to commenters' concerns, we are making minor modifications to the exemption. We are expanding the types of controlling persons covered by the exemption, but we continue to believe that it is appropriate that such representatives have only observer status on, and not be a voting member or chair of, the audit committee. Under the final rule, an audit committee member can be a representative of an affiliate of the foreign private issuer, if the "no compensation" prong of the independence requirements is satisfied, the member in question has only observer status on, and is not a voting member or the chair of, the audit committee, and the member in question is not an executive officer of the issuer. As revised, this limited exception is designed to address foreign practices, assure independent membership and an independent chair of the audit committee and still exclude management from the committee. As the exemption is designed to provide only a limited accommodation for the practices of some foreign private issuers, we are not extending the exemption to domestic issuers, as requested by some commenters.156
iv. Foreign Government Representation
Foreign governments may have significant shareholdings in some foreign private issuers or may own special shares that entitle the government to exercise certain rights relating to these issuers. However, due to their shareholdings or other rights, these representatives may not be considered independent under the final rule. To address foreign practices, we believe that foreign governmental representatives should be permitted to sit on audit committees of foreign private issuers. Commenters supported our proposal to exempt one member of the audit committee that is foreign government representative, provided the "no compensation" prong of the independence requirements is met and the member in question is not an executive officer of the issuer.157 As with the exemption for controlling shareholder representatives, this limited exception is designed to address foreign practices and still exclude management from the committee. However, some believed the exemption should not be limited to just one foreign government representative if the representatives are otherwise independent and are not executive officers of the issuer. Under the final rule, any audit committee member can be a representative of a foreign government or foreign governmental entity, if the "no compensation" prong of the independence requirement is satisfied and the member in question is not an executive officer of the issuer.
We recognize that foreign governments may have varying arrangements relating to their state holdings. Some governments may hold shares directly, some through various branches or agencies, some through an institution organized under public law, and some by other entities. Several commenters believed the legal form of the entity that holds the governmental shareholdings should not be determinative.158 We agree. The exemption applies regardless of the manner in which the foreign government owns its interest.
v. Listed Issuers that are Foreign Governments
Several commenters also requested a specific exemption for listed issuers that are themselves foreign governments, as these issuers most likely would not be able to comply with the requirements. Accordingly, we are exempting in the final rule listed issuers that are foreign governments, as defined in Exchange Act Rule 3b-4(a).159
vi. Boards of Auditors or Similar Bodies
While as noted above there is a continuing trend toward having audit committees in foreign jurisdictions, several foreign jurisdictions require or provide for auditor oversight through a board of auditors or similar body, or groups of statutory auditors, that are in whole or in part separate from the board of directors.160 We believe that these boards of auditors or statutory auditors are intended to be independent of management, although their members may not in all cases meet all of the independence requirements set forth in Section 10A(m) of the Exchange Act. In addition, while these bodies provide independent oversight of outside auditors, they may not have all of the responsibilities set forth in Rule 10A-3. The establishment of an audit committee in addition to these bodies, with duplicative functions, might not only be costly and inefficient, but it also could generate possible conflicts of powers and duties. Accordingly, we proposed an exemption from certain of the requirements for audit committees for boards of auditors or statutory auditors of foreign private issuers that fulfilled the remaining requirements of the rule, if those boards operate under legal or listing provisions intended to provide oversight of outside auditors that is independent of management, membership on the board excludes executive officers of the issuer and certain other requirements were met.
Commenters expressed strong support for the exemption as an appropriate response to address the potential conflicts regarding these alternative structures.161 However, several suggested refinements to the technical wording in the proposed exemption to ensure that it properly covers the appropriate structures in various jurisdictions.162 Also, many requested removing the proposed requirement that the issuer must be listed on a market outside the U.S., as the board of auditor requirement often is a home country legal requirement and not a listing requirement.163 Others believed that the exemption as proposed would not cover the unique situations in some countries where the board of auditors or similar body consists of one or more independent members of the board of directors in addition to one or more non-board members.164 Without a modification, these commenters believed issuers from such jurisdictions could not satisfy the exemption because of the requirement that the board of auditors must be entirely separate from the board of directors. The overwhelming majority of commenters did not believe a sunset provision for the exemption would be appropriate.165
Accordingly, we are making several modifications to the exemption as adopted. Under the final rule, the listing of securities of a foreign private issuer will be exempt from all of the audit committee requirements if the issuer meets the following requirements:
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The foreign private issuer has a board of auditors (or similar body), or has statutory auditors (collectively, a "Board of Auditors"), established and selected pursuant to home country legal or listing provisions expressly requiring or permitting such a board or similar body;
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The Board of Auditors is required to be either separate from the board of directors, or composed of one or more members of the board of directors and one or more members that are not also members of the board of directors;
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The Board of Auditors are not elected by management of the issuer and no executive officer of the issuer is a member of the Board of Auditors;
Home country legal or listing provisions set forth or provide for standards for the independence of the Board of Auditors from the issuer or the management of the issuer;
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The Board of Auditors, in accordance with any applicable home country legal or listing requirements or the issuer's governing documents, is responsible, to the extent permitted by law, for the appointment, retention and oversight of the work of any registered public accounting firm engaged (including, to the extent permitted by law, the resolution of disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the issuer; and
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The remaining requirements in the rule, such as the complaint procedures requirement, advisors requirement and funding requirement, apply to the Board of Auditors, to the extent permitted by law.
This revised formulation is designed to address the jurisdictions that provide for boards of auditors or similar structures. In all instances, the requirements described in the revised exemption are to apply consistent with home country requirements. We recognize that while these bodies are designed to provide independent oversight of outside auditors, they may not meet all of the same requirements or have all of the responsibilities set forth in Exchange Act Rule 10A-3. This approach nonetheless is a preferable method of implementing the protections of the Sarbanes-Oxley Act against the backdrop of this particular category of conflicting home country governance framework.
We have eliminated the requirement that the issuer must also be listed on a market outside the U.S. Also, we are not adopting a sunset date for the exemption. Finally, despite some commenters suggestions, we have not extended the relief to foreign private issuers that have audit committees.166
vii. Requests for Other Foreign Exemptions
A foreign private issuer availing itself of the exemptions discussed in this Section will be subject to specific disclosure requirements discussed in Section II.G.1 below. Consistent with our proposal, there will be no other ability for an SRO to exempt or waive foreign issuers from the requirements. In adopting these exemptions, we recognize that some foreign jurisdictions continue to have historical structures that may conflict with maintaining audit committees meeting the requirements of Section 10A(m) of the Exchange Act. We encourage foreign issuers that access the U.S. capital markets to continue to move toward internationally accepted best practices in corporate governance.167 We also understand that corporate governance structures throughout the world will continue to evolve, and that all future conflicts cannot be anticipated at this time. Accordingly, as requested by many commenters,168 the Commission has the authority to respond to, and will remain sensitive to, the evolving standards of corporate governance throughout the world to address any new conflicts that may arise with foreign corporate governance rules and practices that cannot be anticipated at this time.
b. Small Businesses
Section 10A(m) of the Exchange Act makes no distinction based on an issuer's size. As discussed in the Proposing Release, we think that improvements in the financial reporting process for companies of all sizes are important for promoting investor confidence in our markets. In this regard, because there have been instances of financial fraud at small companies as well as at large companies, we think that improving the effectiveness of audit committees of small and large companies is important.169 The final rule, therefore, applies to listed issuers of all sizes as proposed.
The majority of commenters generally agreed with this approach and did not support lesser standards for smaller issuers.170 These commenters did not believe the requirements will impose a disproportionate burden on small issuers. A few commenters, however, were concerned that smaller issuers may have particular difficulty locating qualified audit committee candidates that will meet the independence criteria, especially given the implementation period proposed by the Commission.171 While these commenters advocated various approaches, such as an exceptional and limited circumstances exemption for smaller issuers or SRO authority to exempt individual small issuers on a case-by-case basis, most agreed that an additional initial implementation period would be appropriate for these issuers.
We recognize that because the final rule applies only to listed issuers, quantitative listing standards applicable to listed securities, such as minimum revenue, market capitalization and shareholder equity requirements, will limit the size of issuers that will be affected by the requirements.172 However, we are sensitive to the possible implication for smaller issuers and for SROs that would like to specialize in securities of these issuers. As discussed in Section II.F.1, we are providing an extended compliance period for listed issuers that are small business issuers. In addition, the modifications to several of the other exemptions in the final rule, such as the overlapping board exemption and the new issuer exemption, should provide additional flexibility to small and new issuers in meeting the requirements of the rule. Our approach of not mandating specific procedures for the auditor responsibility requirement and the complaint procedures requirement also should provide issuers flexibility in meeting these requirements.
c. Issuers of Asset-Backed Securities and Certain Other Passive Issuers
In several of our releases implementing provisions of the Sarbanes-Oxley Act,173 we have noted the special nature of asset-backed issuers.174 Because of the nature of these entities, such issuers are subject to substantially different reporting requirements. Most significantly, asset-backed issuers are generally not required to file the types of financial statements that other companies must file. Also, such entities typically are pass