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“Firing Line,” Time (February 19, 1979), p. 51.
Legal Cases Involving the Audit Committee 153


briefly reviewed in order to demonstrate the philosophy of the courts and the SEC
with respect to the audit committee.

The Penn Central Case
On August 3, 1972, the SEC released its study regarding the financial collapse of
the Penn Central Company to a Special Subcommittee on Investigations of the
House of Representatives. With respect to the role of the directors, the SEC found
that the directors had a passive role in company affairs. They avoided confrontation
with management on issues that were critical to testing the integrity of management
and to providing adequate disclosure to the stockholders. For example, the com-
pany™s CFO was involved in a lawsuit that claimed improper, unlawful conduct in
connection with a subsidiary and a private investment club. Although the board au-
thorized an investigation, it later cancelled the investigation because the CFO
threatened to resign. As a result, the financial management was permitted to oper-
ate without any effective review of control by the board.28 In particular, the Com-
mission noted that the directors have a responsibility to obtain from management
information that is adequate in both “quantity and quality” in order to discharge
their state corporate legal liability. For example, a new director indicated that “lists
of new equipment did not particularly help him discharge his responsibilities and
thus information regarding the corporate objectives and plans was necessary to do
the job.”29 Furthermore, the Commission emphasized the “critical importance” of
the director™s responsibility as well as “greater utilization of public and independent
directors.” Such independent directors should be judged on the “reasonableness of
their judgment.”30 Thus the Commission™s findings and conclusions point toward
the need for an advisory committee of outside directors. The audit committee would
fulfill this particular purpose.

Lum™s, Inc. Case
On April 11, 1974, the SEC obtained a consent injunction from the U.S. District
Court against Lum™s, Inc. whereby the registrant “agreed not to employ any ma-
nipulative scheme to defraud and not to commit any proxy fraud in connection
with future acquisitions of businesses or business assets.” More specifically, the
court ordered that the registrant had to include this information in its registration
or proxy statement:

1. The identity of the individuals who control the acquired business
2. Any material consideration to be paid for the acquiring business in addition to
the purchase price
3. Any material information known indicating that the earnings of an acquired
business were affected by the failure of management to maintain proper ac-
counting records and internal controls

28
Commerce Clearing House, Federal Securities Law Reporter, par. 78,931.
29
Ibid.
30
Ibid.
154 The Legal Position of the Audit Committee


Furthermore, the registrant had to establish a standing audit committee to review
the accountant™s evaluations of the system of internal controls and to review other
casino activities in terms of personnel and security. The court required that the
audit committee consist of two or more members of the board of directors who are
not officers or employees of the company.31 The Lum™s consent injunction is of
particular importance because it was the impetus toward the establishment of a
standing audit committee through court action.

Mattel, Inc. Case
In the Mattel case of SEC v. Mattel, Inc. (October 1, 1974), the Commission
sought a consent injunction against the registrant for false financial reporting. The
Commission charged not only that the registrant™s financial statements for 1971
were overstated by $14 million in sales that were subject to customer cancellation
but also that the pretax income was overstated by $10.5 million due to inadequate
accounting provisions. As a result, the U.S. District Court ordered Mattel to es-
tablish and maintain a financial controls and audit committee whereby three of the
four members must be unaffiliated directors. In particular, the court required that
the committee have these five duties and functions:

1. Review the financial controls and accounting procedures and recommend im-
provements to management.
2. Review the quarterly financial statements to determine whether such reports
are in conformity with generally accepted accounting principles.
3. Review all releases and other information to the news media, general public,
and stockholders with respect to the financial condition of the company and
approve or disapprove such dissemination.
4. Review the results of the independent audit examination of the financial
statements.
5. Approve or disapprove any change of the independent auditors.32

Thus, through a consent injunction against Mattel, it is clearly evident that the SEC
continued to rely more heavily on the independent audit committee to review and
monitor the company™s financial controls, accounting procedures, and financial
statements. Also, this particular legal action provided an initial framework for the du-
ties and functions of the committee. Indeed, the question of what constitutes proper
standards and practices for the committee was emerging through a court settlement;
as a consequence the court was dictating the responsibilities of the audit directors.
Such an approach is further evidenced by the results of the Killearn Properties case.

Killearn Properties, Inc. Case
In the SEC v. Killearn Properties, Inc. case (May 1977), the SEC outlined its di-
rectives concerning the audit committee as part of a consent judgment. The de-

31
Ibid., par. 94,504.
32
Ibid., par. 94,807.
Legal Cases Involving the Audit Committee 155


fendants were enjoined from directly or indirectly making use of the mails or
other communication to transmit any prospectus regarding the stock since the
prospectus must meet the requirement of the securities laws. More specifically, the
court ordered the defendants to observe the following policies and practices with
respect to the audit committee:

B. The Board of Directors shall continue to maintain an Audit Committee (“Com-
mittee”) of the Board consisting of at least Three (3) persons who shall be members
of the Board and outside directors of Killearn. The Committee shall assume, upon
the entering of this Order, the following duties, functions and responsibilities:
i. It should review the engagement of the independent accountants, including the
scope and general extent of their review, the audit procedures which will be utilized,
and the compensation to be paid.
ii. It should review with the independent accountants, and with the company™s chief
financial officer (as well as with other appropriate company personnel) the general
policies and procedures utilized by the company with respect to internal auditing, ac-
counting, and financial controls. The members of the committee should have at least
general familiarity with the accounting and reporting principles and practices applied
by the company in preparing its financial statements.
iii. It should review with the independent accountants, upon completion of their
audit, (a) any report or opinion proposed to be rendered in connection therewith; (b)
the independent accountants™ perceptions of the company™s financial and accounting
personnel; (c) the cooperation which the independent accountants received during
the course of their review; (d) the extent to which the resources of the company were
and should be utilized to minimize time spent by the outside auditors; (e) any sig-
nificant transactions which are not a normal part of the company™s business; (f) any
change in accounting principles; (g) all significant adjustments proposed by the au-
ditor; (h) any recommendations which the independent accountants may have with
respect to improving internal financial controls, choice of accounting principles, or
management reporting systems.
iv. It should inquire of the appropriate company personnel and the independent au-
ditors as to any instances of deviations from established codes of conduct of the com-
pany and periodically review such policies.
v. It should meet with the company™s financial staff at least twice a year to review
and discuss with them the scope of internal accounting and auditing procedures then
in effect; and the extent to which recommendations made by the internal staff or by
the independent accountants have been implemented.
vi. It should prepare and present to the company™s board of directors a report sum-
marizing its recommendation with respect to the retention (or discharge) of the in-
dependent accountants for the ensuing year.
vii. It should have a power to direct and supervise an investigation into any matter
brought to its attention within the scope of its duties (including the power to retain
outside counsel in connection with any such investigation).
In addition, the Audit Committee shall have the following special duties, functions
and responsibilities:
viii. review, either by the Committee as a whole or by a designated member, all
releases and other information to be disseminated by Killearn to press media, the
156 The Legal Position of the Audit Committee


public, or shareholders of Killearn which concern disclosure of financial conditions
of and projections of financial conditions of Killearn and its subsidiaries;
ix. review of the activities of the officers and directors of Killearn as to their future
dealing with the company and take any action the Committee may deem appropriate
with regard to such activities;
x. approve any settlement or disposition of any claims or actions from causes of action
arising after the date hereof or any litigation now pending which Killearn may have
against any past or present officers, directors, employees or controlling persons.33


U.S. Surgical Corporation
In February 1984, the SEC filed an action against U.S. Surgical Corporation and six
of its senior executives, alleging numerous improper financial reporting practices
from 1979 to 1981. The corporation™s pretax earnings were overstated by more than
$18 million. This overstatement amounted to 56 percent of the pretax earnings re-
ported during 1979 and 1981. In addition, the improper accounting practices con-
tinued during 1982 and 1983. In the final consent order, the corporation agreed to
appoint two new independent directors to the audit committee and define new re-
sponsibilities of the audit committee. In particular, the committee was required to:

Review for a period of at least five years, prior to release, all earnings reports and the
financial statements that accompany the annual audit and quarterly review reports of
the external auditors and reports of the internal audit department;
Engage the external auditors to review and report to the committee on accounting
policies concerning review recognition, capitalization of certain costs, inventories,
R&D expenses, and accruals; and
Engage an accounting firm (advisory accountants) for a period of three years to re-
view the services performed by the external auditors, and to assist the committee on
other matters as requested34

This case demonstrated the need for the board of directors through its audit com-
mittee to exercise its oversight responsibility for the internal and external auditing
processes and financial reporting disclosures.
Based on a review of the court actions, it is apparent that the audit committee
has been established to oversee and monitor the conduct of the corporate officials.
Although the committee is not directly involved with the day-to-day management
affairs, the SEC and the courts forced the registrants to establish committees in
order to comply with the requirements of the federal securities laws. Such legal en-
forcement of the courts has augmented not only the audit directors™ legal obliga-
tions but also their standard of duty and loyalty to the enterprise.
The critical involvement of audit committees is highlighted by such companies
as California Life Corporation, Playboy Enterprises, Inc., and H.J. Heinz Co.
Some of the excerpts from The Wall Street Journal involving these companies are
used to illustrate the audit committee™s involvement.

33
Ibid., par. 96,256.
34
Ibid., par. 105,124.
Legal Cases Involving the Audit Committee 157


California Life Corporation
When the audit committee learned that Cal Life was late in filing its 1978 annual fi-
nancial statements with the SEC, the committee began an investigation. The late fil-
ing was the result of a dispute between management and its independent auditors. As
Lancaster reported: “Certainly, the committee had some mitigating problems: a new,
inexperienced committee chairman, a chief executive who was hard to deal with, and
complex and unanticipated accounting issues.” With a high expected loss rate on in-
surance premiums, the auditors lacked confidence that the deferred costs related to
new policies could be recovered from future profits. As a result of this disagreement,
the company reported a $3.2 million loss rather than an anticipated $2.6 million
profit. Given the situation at Cal Life, a number of actions were taken to improve the
financial reporting process. In particular, the senior executives of the firm were re-
placed and the membership of the audit committee increased to five from three. The
committee had convened six times as opposed to two meetings and assumed an ac-
tive role in overseeing the audit processes.35

Clearly, this case demonstrated that the audit committee is a viable mechanism in
helping boards of directors discharge their oversight responsibilities for the finan-
cial reporting process. There is little question that the committee has assumed
greater responsibilities.

Playboy Enterprises, Inc.
In the Playboy Enterprises case, the audit committee requested that Hugh Hefner,
chief executive officer of Playboy, and four other executives return to the company
more than $900,000. The amounts owed by these parties involved perquisites
(perks), such as the use of the DC-9 plane and the value of benefits (lodging,
meals, valet, etc.) received from the company. As a result, the aforementioned par-
ties repaid their perks and the board also established a compensation committee.36
Thus the audit committee™s close scrutiny of these activities did unearth a signifi-
cant problem area before it impaired the integrity of the company.


H.J. Heinz
From 1972 to 1979, Heinz was involved in profit-juggling practices at several di-
visions. More specifically, the audit committee reported that “the practices, de-
signed to give the appearance of smooth profit growth of the divisions, stemmed
partly from inadequate internal accounting controls, poor internal communica-
tions, the autonomy of division accountants and careless review of division reports
by the Heinz corporate staff.”37 To correct these practices, the audit committee rec-
ommended more internal auditors, more corporate supervision of division ac-
countants, and a tougher corporate code of conduct. In addition, the audit
committee recommended changing the outside auditing firm, and, as a result,

35
Hal Lancaster, “Fuss at Cal Life Shows Audit Committee Role Is Critical,” Wall Street Journal
(March 17, 1980), p. 1.
36
Wall Street Journal Staff Reporter, “Playboy Audit Committee Bares Details of Hefner™s High Liv-
ing on Firm™s Tab,” Wall Street Journal (April 4, 1980), p. 6.
158 The Legal Position of the Audit Committee


another multinational accounting firm is now the auditor. Furthermore, the com-
pany hired an outside law firm and another large accounting firm to assist in the
special investigation.38 Clearly, Heinz™s audit committee proved to be a very strong
and effective operating tool of the company. Its involvement established a high de-
gree of confidence in the quality of the financial reports and disclosures to stock-
holders, underwriters, and financial analysts. Exhibits 4.1, 4.2, and 4.3 contain a
discussion of possible warning signals and “red flags.”
As Hugh L. Marsh and Thomas E. Powell assert:
It would be a misconception to believe the possibility of fraud is the only reason for
establishing a chartered audit committee. While the primary role has been to oversee
management™s financial and reporting responsibilities, the Treadway Commission™s

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