The Expanded Role of Audit Committees Following the Sarbanes-Oxley Act of 2002


Gibbons Special Alert

August 21, 2002

On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 (the “Act”), implementing the most substantial redesign of corporate governance and disclosure law in almost 70 years. The Act applies to any “Issuer” of securities that are required to be registered or that is required to file reports under the Securities Exchange Act of 1934 (the “Exchange Act”). The Act applies also to an Issuer that has a registration statement pending under the Securities Act of 1933, provided such statement is not withdrawn.

In addition to its other provisions, the Act expressly governs the operation of corporate Audit Committees. The Act defines an “Audit Committee” as “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.” Interestingly, the Act does not require an Issuer to maintain an Audit Committee. Instead, where an Audit Committee does not exist, the Act provides that the entire board of directors will serve as the Issuer’s Audit Committee. The precise implications of such provision are yet unknown.

Amendment to the Exchange Act

  • Preapproval of Services. The Act amends Section 10A of the Exchange Act (i.e., Audit Requirements) to provide that all 1) auditing services, including, without limitation, the issuance of comfort letters in connection with securities underwritings or statutory audits, and 2) non-de minimus permitted non-auditing services, must be preapproved by the Issuer’s Audit Committee. Approvals of such non-auditing services must be disclosed in the Issuer’s periodic public reports. Such preapproval power may be delegated by the Audit Committee to one or more of its members, whose decisions must be presented to the entire Audit Committee at its scheduled meetings.

Required SEC Rulemaking By No Later Than January 26, 2003

  • Presence of Financial Expert on the Audit Committee. The Act directs the Securities and Exchange Commission (the “SEC”) to propose, by no later than October 28, 2002, and to issue, by no later than January 26, 2003, rules requiring Issuers to disclose whether their Audit Committee has at least one “Financial Expert” as a member, and if not, to explain the reason behind the absence of such individual. The Act delegates to the SEC the definition of “Financial Expert”, but requires the SEC to consider whether a person has, through education and prior experience as a public accountant or auditor, principal financial or accounting officer of an Issuer, comptroller of an Issuer or analogous position:
      • a comprehension of generally accepted accounting principles and financial statements;
      • experience in the preparation or auditing of financial statements of similar Issuers and the application of such principles in association with the accounting for estimates, accruals and reserves;
      • experience with internal accounting controls; and
    • a comprehension of Audit Committee functions.

Required SEC Rulemaking By No Later Than April 26, 2003

  • Prohibition on Listing for Audit Committee Noncompliance. The Act expressly requires that the SEC adopt, by no later than April 26, 2003, rules directing the national securities exchanges and associations to prohibit the listing of the securities of any Issuer whose Audit Committee is not in compliance with the following:
      • Responsibilities. The Audit Committee is directly responsible for the appointment, compensation and oversight of any public accounting firms employed by the Issuer, including, without limitation, the resolution of disagreements between the Issuer’s management and outside auditors regarding financial reporting. Such public accounting firms must report directly to the Audit Committee.

      • Committee Independence. Each member of the Audit Committee is an independent member of the Issuer’s board of directors. To qualify as an “Independent” director under the Act, the director must neither be affiliated with the Issuer or a subsidiary thereof, nor accept any fees (including consulting or advisory fees) from the Issuer other than in his or her capacity as a member of the Issuer’s board of directors or Audit Committee. Notwithstanding the foregoing, the Act grants the SEC the power, at its discretion, to exempt from such requirements certain Audit Committee members.

      • Accounting and Auditing Complaints. The Audit Committee has established procedures for receiving and addressing complaints regarding auditing matters and accounting matters and the internal controls thereof, including a means whereby employees can confidentially and anonymously submit concerns regarding questionable auditing or accounting practices.

    • Authority to Engage and Compensate Advisors. At its discretion, the Audit Committee has the power to engage independent counsel and other advisers, and require the Issuer to provide appropriate funding for the payment of compensation to such individuals and to any registered public accounting firm hired to prepare an audit report.

In sum, the Act significantly modifies the manner in which the Audit Committee of an Issuer must operate. As the SEC implements additional rules interpreting the Act, the regulation of Audit Committees will be modified further. It is essential that every Issuer ensure that at all times its Audit Committee operates in compliance with the Act and forthcoming SEC rulemaking.

Gibbons intends to update the information contained in this publication as the SEC issues further pronouncements. We would be pleased to discuss the Act with you (including the Audit Committee rules discussed above), provide you with advice on the legal consequences of the Act and assist you in formulating a plan for compliance with the Act.