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with Generally Accepted Accounting Principles in the Independent Auditor™s Report” (New
York: AICPA, 1992).
Statement on Auditing Standards No. 90, “Audit Committee Communications” (New York:
AICPA, 1999).
U.S. General Accounting Office, Financial Statement Restatements: Trends, Market Im-
pacts, Regulatory Responses, and Remaining Challenges GAO-03-138 (October 4, 2002),
www.gao.gov/gao-03-138.
Wal-Mart Stores, Inc., Audit Committee Charter 2003 www.walmartstores.com, pp. 1“7.
Wal-Mart Stores, Inc., 2003 Annual Report.
Chapter 4
The Legal Position of the
Audit Committee

Recall from the discussion in Chapter 2 that the Sarbanes-Oxley Act of 2002 and
the SEC final rules regarding the composition, roles, and responsibilities of audit
committees have established a specific body of law that governs audit committees.
Likewise, the legal obligations of audit committee members are manifested in
state corporation laws and certain other federal statutes regarding directorate re-
sponsibilities. The purpose of this chapter is to review the general legal responsi-
bilities of the committee as well as several legal cases involving the committee. In
addition, securities litigation (see Exhibit 4.1) and the guidelines for minimizing
the committee™s possible legal liability are presented to put the legal position of the
audit directors in proper perspective.1
The latter portion of Chapter 2 described the legal environment of audit com-
mittees under the federal statute and amendments to the federal securities laws. Al-
though the legal provisions are not repeated in this chapter, these three points are
reemphasized:

1. The Sarbanes-Oxley Act significantly increases the audit committee™s respon-
sibilities, including the cost of directors and officers liability insurance.
2. To help the boards of directors fulfill their fiduciary responsibilities to the
stockholders, audit committees should consider their use of authority under
Section 301 of the act to engage independent counsel and other advisers. In
contrast, the audit committee™s legal responsibilities under general corporate
law are similar because they may rely on accounting, legal, or other experts
when acting in good faith. Such action could be considered an act of due dili-
gence. Such inaction could be considered an act of malfeasance.
3. Finally, the roles, responsibilities, and functions of audit committees should be
specific and in compliance with the laws and regulations. The major objective
is to avoid additional responsibilities that make the audit committee members
vulnerable to claims of a breach of fiduciary responsibilities. (For further in-
formation regarding such matters as the business judgment rule, see the
Delaware Court of Chancery, In Re Caremark International Inc. Derivative
Litigation, 698 A. 2d 959 (Del. Ch. 1996) and the section on legal cases in this
chapter. Also see William C. Powers, Report of Investigation by the Special
Investigative Committee of the Board of Directors of Enron Corporation (Feb-
ruary 1, 2002) at www.news.findlaw.com/hdocs/docs/enron/sicreport/).
1
Although reference is made to both the federal and state statutes, such references provide only a de-
scription of the law. One should have recourse to legal counsel for the appropriate legal interpretation.

143
144 The Legal Position of the Audit Committee


GENERAL LEGAL RESPONSIBILITIES
State Statutes
Although the board of directors has the statutory power to establish standing
committees of the board, several state corporation laws limit the board™s powers to
delegate authority and responsibility. For example, the New York statute provides
that:

. . . No such committee shall have authority as to the following matters:
1. The submission to shareholders of any action that needs shareholder™s authoriza-
tion under this chapter
2. The filling of vacancies in the board of directors or in any committee
3. The fixing of compensation of the directors for serving on the board or on any
committee
4. The amendment or repeal of the bylaws, or the adoption of new bylaws
5. The amendment or repeal of any resolution of the board which by its terms shall
not be so amendable or repealable2

Thus the audit committee has limited authority; however, such authority is dis-
cretionary because the audit directors can exercise their own judgment in the in-
terest of the board. Moreover, the audit committee, since it is formally constituted,
is free to meet in between the board meetings.
More important, each member of the board of directors and the standing com-
mittees has a statutory duty of care because of the fiduciary relationship between
the directors and the corporation. With respect to the duties of the directors and of-
ficers, the New York statute indicates:

Directors and officers shall discharge the duties of their respective positions in good
faith and with that degree of diligence, care and skill which ordinarily prudent men
would exercise under similar circumstances in like positions. In discharging their du-
ties, directors and officers, when acting in good faith, may rely upon financial state-
ments of the corporation represented to them to be correct by the president or the
officer of the corporation having charge of its books of accounts, or stated in a writ-
ten report by an independent public or certified public accountant or firm of such ac-
countants fairly to reflect the financial condition of such corporations.3
Furthermore, since the directors serve the corporation in a fiduciary capacity,
their statutory duty of care cannot be delegated because of the personal nature of
the director™s relationship with the corporation. Hence although the audit com-
mittee can make recommendations to the entire board, the final decisions are made
by the board because it has overall responsibility for the committee™s actions. In
short, the standing committees of the board cannot eliminate each director™s duties
and obligations because of the fiduciary principle.


2
New York Business Corporation Law, Sec. 712, McKinney™s Consolidated Laws of New York Anno-
tated, Book 6 (Brooklyn, NY: Edward Thompson Company, 1963).
3
Ibid., Sec. 717.
General Legal Responsibilities 145


Particularly important to the concept of the duty of care is the degree of care.
To measure its reasonableness, several state corporation laws provide a business
judgment rule. Such a rule protects the directors against personal liability on the
presumption that they acted not only in good faith but also exercised reasonable
care and prudence regarding their decisions. Thus, in the absence of fraud, bad
faith, or negligence, a director cannot be held personally liable concerning matters
of corporate policy and business judgment.4
Furthermore, the directors may be personally liable for negligence with respect
to losses suffered by the corporation.5 The directors can be held jointly and sever-
ally liable to the corporation whereby an injured stockholder or creditor can re-
cover a loss from the individual director, several directors, or the full board. For
example, if the directors vote to declare dividends from the corporation™s capital
rather than from its retained earnings, then they are liable because their actions
constitute an unauthorized dividend distribution.6
Equally important, directors have a duty of loyalty regarding their activities
with the corporation. They cannot exploit the corporation for personal gain be-
cause of their fiduciary relationship. For example, if a director has a personal in-
terest in a particular corporate transaction, then the director should disassociate
him- or herself from the transaction because of the apparent conflict of interest.
Thus, each director has an “undivided loyalty and an allegiance” with respect to
the interests of the corporation and stockholders.7
Moreover, in 1978 the American Bar Association amended Section 35 of its
Model Business Corporation Act, which, if adopted as part of the state corporation
statutes, increases a director™s reliance on the board™s standing committees. Specif-
ically, the amendment provides that a director may rely on the information that is
presented by a committee although the director is not a member of this group.
Such reliance on the board committee is based on the director™s confidence in the
committee. However, when relying on the committee, the director must adhere to
the duty-of-care principle whereby the director should be familiar with the com-
mittee™s activities. In short, the amendment allows a director to rely on the work
of a committee that has an oversight or supervisory responsibility, such as the audit
committee. Accordingly, the amendment poses certain questions regarding the
legal implications of the committee since it appears that a noncommittee director
may be exonerated from any potential liability provided that he or she has exer-
cised his or her duty of care.8

4
Ibid.
5
For example, if it can be proven that a director has breached his or her fiduciary duty to the corpora-
tion, then the director may be held personally liable for the losses suffered by the corporation.
6
New York Business Corporation Law, Sec. 719.
7
Ibid., Sec. 717.
8
American Bar Association, Corporate Director™s Guidebook (Chicago: ABA, 1978), p. 42. Also see
American Bar Association, Corporate Director™s Guidebook, 2nd ed. (Chicago: ABA, 1994). Finally,
the reader may wish to review the Escott v. BarChris Construction Corp. case, 283 F, Supp. 643
(S.D.N.Y. 1968), which deals with the standard of differential liability. In short, the court states that a
director with a particular expertise and access to information may be held to a higher standard of liabil-
ity. Of course, the performance of individual audit committee members is based on their skills and qual-
ifications and access to information. Thus a member with an accounting background would be more
aware of the accounting and auditing implications than would be a member without this expertise.
146 The Legal Position of the Audit Committee


The state of Connecticut has enacted legislation that requires companies in-
corporated with at least 100 stockholders to establish an audit committee. In
Sections 33-318(b)(1) and 33-318(b)(2), the statute defines the standard of inde-
pendence and the functions of the audit committee. See the Connecticut General
Statutes Annotated in West 1960 and Supplement 1985 (Eagan, MN.: West Pub-
lishing Corporation) for further details.
In 1984, the American Bar Association adopted a Revised Model Business
Corporation Act. In 1998, the American Bar Association adopted the Model Busi-
ness Corporate Act. Section 8.25 of the act stipulates that a board of directors may
create standing committees, such as an audit committee. This stipulation is con-
sistent with the statutory provisions at the state level. In addition, Section 8.3(0),
which deals with the standards of conduct for directors, indicates that a director is
entitled to rely on information, opinions, reports, or statements”including finan-
cial statements”prepared by officers of the corporation and public accountants. A
director is also entitled to rely on the opinions of legal counsel as well as on the
work of a standing committee of the board of which he or she is not a member.
Thus the American Bar Association has reaffirmed its position with respect to
good-faith reliance on officers, public accountants, legal counsel, and committee
members of the board. (See Appendix F on this book™s website.)


Federal Statutes”Key Sections
In addition to their legal responsibilities at the state level, the directors have a legal
liability at the federal level. The federal statutes that are particularly important are
summarized below.

Although this particular act provides financial infor-
Securities Act of 1933
mation regarding the public sale of securities, it is needed “to prohibit misrepre-
sentation, deceit, and other fraudulent acts and practices in the sale of securities.”9
In particular, this act provides for civil liability of the directors with respect to
fraud in the registration statement. Section 11(a) of the act provides that:

(1) In case any part of the registration statement, when such part became effective,
contained an untrue statement of a material fact or omitted to state a material fact
required to be stated therein or necessary to make the statement therein not mis-
leading, any person acquiring such security (unless it is proved that at the time
of such acquisition he knew of such untruth or omission) may, either at law or in
equity, in any court of competent jurisdiction, sue”
(2) Every person who was a director of . . . the issuer at the time of the filing of the
part of the registration statement . . .10



9
Securities and Exchange Commission, The Work of the Securities and Exchange Commission (Wash-
ington, DC: U.S. Government Printing Office, 1974), p. 1.
10
U.S. Code, Title 15, Sec. 77k.
General Legal Responsibilities 147


In order to avoid any liability, Sections 11(b) and 11(c) of the act provide:

Notwithstanding the provisions of subsection (a) of this section no person, other
than the issuer, shall be liable as provided therein who shall sustain the burden of
proof
(1) that before the effective date of the part of the registration statement with respect
to which his liability is asserted (A) he had resigned from or had taken such steps
as are permitted by law to resign from, or ceased or refused to act in, every office,
capacity, or relationship in which he was described in the registration statement
as acting or agreeing to act, and (B) he had advised the Commission and the is-
suer in writing that he had taken such action and that he would not be responsi-
ble for such part of the registration statement; or
(2) that if such part of the registration statement became effective without his knowl-
edge, upon becoming aware of such fact he forthwith acted and advised the Com-
mission, in accordance with paragraph (1) of this subsection, and, in addition,
gave reasonable public notice that such part of the registration statement had be-
come effective without his knowledge, or
(3) that (A) as regards any part of the registration statement not purporting to be
made on the authority of an expert, and not purporting to be a copy of or extract
from a report or valuation of an expert, and not purporting to be made on the au-
thority of a public official document or statement, he had, after reasonable inves-
tigation, reasonable ground to believe and did believe, at the time such part of the
registration statement became effective, that the statements therein were true and
that there was no omission to state a material fact required to be stated therein or
necessary to make the statements therein not misleading; and (B) as regards any
part of the registration statement purporting to be made upon his authority as an
expert or purporting to be a copy of or extract from a report or valuation of him-
self as an expert, (i) he had, after reasonable investigation, reasonable ground to
believe and did believe at the time such part of the registration statement became
effective, that the statements therein were true and that there was no omission to
state a material fact required to be stated therein or necessary to make the state-
ments therein not misleading, or (ii) such part of the registration statement did not
fairly represent his statement as an expert or was not a fair copy of or extract from
his report or valuation as an expert; and (C) as regards any part of the registration
statement purporting to be made on the authority of an expert (other than himself)
or purporting to be a copy of or extract from a report or valuation of an expert
(other than himself), he had no reasonable ground to believe and did not believe,
at the time such part of the registration statement became effective, that the state-
ments therein were untrue or that there was an omission to state a material fact re-
quired to be stated therein or necessary to make the statements therein not
misleading, or that such part of the registration statement did not fairly represent
the statement of the expert or was not a fair copy of or extract from the report of
valuation of the expert; and (D) as regards any part of the registration statement
purporting to be a statement made by an official person or purporting to be a copy
of or extract from a public official document, he had no reasonable ground to be-
lieve and did not believe, at the time such part of the registration statement be-
came effective, that the statements therein were untrue, or that there was an
omission to state a material fact required to be stated therein or necessary to
make the statements therein not misleading, or that such part of the registration
148 The Legal Position of the Audit Committee


statement did not fairly represent the statement made by the official person or was
not a fair copy of or extract from the public official document.

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