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that such entities were independent from the company. In
fact, such entities were used as off-balance sheet financing
arrangements inappropriately secured by debt rather than
equity securities. The defendant agree to disgorge and
forfeit approximately $12 million as well as submit a
guilty plea in related criminal proceedings with the U.S.
Department of Justice.




Source: The Securities and Exchange Commission Annual Reports (Washington, DC: U.S. Govern-
ment Printing Office, 1990“1997 and 1998“2002).
Legal Cases Involving the Audit Committee 169


high. But, a demanding test of liability in the oversight context is probably beneficial
to corporate shareholders as a class, as it is in the board decision context, since it
makes board service by qualified persons more likely, while continuing to act as a
stimulus to good faith performance of duty by such directors.
Here the record supplies essentially no evidence that the director defendants were
guilty of a sustained failure to exercise their oversight function. To the contrary, in-
sofar as I am able to tell on this record, the corporation™s information systems appear
to have represented a good faith attempt to be informed of the relevant facts. If the
directors did not know the specifics of the activities that lead to the indictments, they
cannot be faulted.
The liability that eventuated in this instance was huge. But the fact that it resulted
from a violation of criminal law alone does not create a breach of fiduciary duty by
directors. The record at this stage does not support the conclusion that the defendants
either lacked good faith in the exercise of their monitoring responsibilities or con-
scientiously permitted a known violation of law by the corporation to occur. The
claims asserted against them must be viewed at this stage as extremely weak.43


Recent Developments
Section 307 of the Sarbanes-Oxley Act of 2002 mandates that the Securities and
Exchange Commission:

shall issue rules, in the public interest and for the protection of investors, setting forth
minimum standards of professional conduct for attorneys appearing and practicing
before the commission in any way in the representation of issuers, including a rule”
(1) requiring an attorney to report evidence of a material violation of securities law
or breach of fiduciary duty or similar violation by the company or any agent
thereof, to the chief legal counsel or the chief executive officer of the company
(or the equivalent thereof); and
(2) if the counsel or officer does not appropriately respond to the evidence (adopt-
ing, as necessary, appropriate remedial measures or sanctions with respect to the
violation), requiring the attorney to report the evidence to the audit committee of
the board of directors of the issuer or to another committee of the board of di-
rectors comprised solely of directors not employed directly or indirectly by the
issuer, or to the board of directors.44

Furthermore, the American Bar Association Task Force on Corporate Respon-
sibility recommended adoption of these governance policies as ABA policy:

1. The board of directors of a public corporation must engage in active, inde-
pendent and informed oversight of the corporation™s business and affairs, in-
cluding its senior management.


43
See In Re Caremark International Inc. Derivative Litigation, 698 A. 2d 959 (Del. Ch. 1996).
44
Sarbanes-Oxley Act of 2002, Section 307, Rules of Professional Responsibility for Attorneys, H.R.
Rep. No. 107-610 (2002). For further information regarding the standards for professional conduct of
attorneys, see Securities and Exchange Commission, Release No. 33-8155, Implementation of Stan-
dards of Professional Conduct for Attorneys (January 29, 2003).
170 The Legal Position of the Audit Committee


2. In order to improve the effectiveness of such oversight, the board of directors
of a public corporation should adopt governance principles (more fully spec-
ified in Part VI of this Report) that (a) establish and preserve the independence
and objectivity of directors by eliminating disabling conflicts of interest and
undue influence or control by the senior management of the corporation and
(b) provide the directors with timely and sufficient information and analysis
necessary to the discharge of their oversight responsibilities.
3. The directors should recognize and fulfill an obligation to disclose to the board
of directors information and analysis known to them that is relevant to the
board™s decision making and oversight responsibilities. Senior executive offi-
cers should recognize and fulfill an obligation to disclose, to a supervising of-
ficer, the general counsel, or the board of directors or committees of the board,
information and analysis relevant to such persons™ decision making and over-
sight responsibilities.
4. Providing information and analysis necessary for the directors to discharge
their oversight responsibilities, particularly as they relate to legal compliance
matters, requires the active involvement of general counsel for the public cor-
poration. (If a public corporation has no internal general counsel, it should
identify and designate a lawyer or law firm to act as general counsel. The re-
sponsibility for implementing these recommended policies may necessarily be
delegated to some extent by the general counsel to subordinate lawyers.)
5. A lawyer representing public corporation shall serve the interests of the entity,
independent of the personal interests of any particular director, officer, em-
ployee or shareholder.
6. The general counsel of a public corporation should have primary responsibil-
ity for assuring the implementation of an effective legal compliance system
under the oversight of the board of directors.
7. Public corporations should adopt practices in which:
a. The selection, retention, and compensation of the corporation™s general
counsel are approved by the board of directors.
b. General counsel meets regularly and in executive session with a committee
of independent directors to communicate concerns regarding legal compli-
ance matters, including potential or ongoing material violations of law by,
and breaches of fiduciary duty to, the corporation.
c. All reporting relationships of internal and outside lawyers for a public cor-
poration establish at the outset a direct line of communication with general
counsel through which these lawyers are to inform the general counsel of
material potential or ongoing violations of law by, and breaches of fidu-
ciary duty to, the corporation.
8. The model Business Corporation Act and the general corporation laws of the
states, and the courts interpreting and applying the duties of directors, should
more clearly delineate the oversight responsibility of directors generally, and
the unique role that independent directors play in discharging that responsi-
bility in public company settings. (Among the specific oversight matters that
should be considered in relation to the Model Business Corporation Act or its
commentary and the state corporate laws as well as in relation to important
guidance such as the Corporate Director™s Guidebook are at least the follow-
ing: selecting, evaluating, and compensating the chief executive officer and
other members of senior management; reviewing, approving, and monitoring
Legal Cases Involving the Audit Committee 171


fundamental financial and business strategies and the performance of the
company relative to those strategies; assessing major risks facing the com-
pany; and ensuring that reasonable processes are in place to maintain the in-
tegrity of the company and the corresponding accountability of senior
management, including processes relating to integrity of financial reporting,
compliance with law and corporate codes of legal and ethical conduct, and
processes designed to prevent improper related party transactions. Federal
law [particularly the securities law, including the rules and regulations adopted
by the SEC] also plays a significant role in affecting and promoting corporate
responsibility.)
9. Engagements of counsel by the board of directors, or by a committee of the
board, for special investigations or independent advice should be structured
to assure independence and direct reporting to the board of directors or the
committee.
10. The SEC and the state attorney disciplinary authorities should cooperate in
sharing information in order to promote effective and appropriate enforce-
ment of rules of conduct applicable to counsel to public corporations.
11. The courts, law schools and lawyer professional organizations such as the
ABA should promote awareness of, and adherence to, the professional re-
sponsibilities of lawyers in their representation of public corporations.
12. Law firms and law departments should adopt procedures to facilitate and
promote compliance with rules of professional conduct governing the repre-
sentation of public corporations. (In its Preliminary Report [at 43], the task
force stated its intention to consider issues involving potential conflicts of in-
terest arising out of lawyers™ business and investment relationships with
clients. The testimony submitted to the Task Force, however, did not signif-
icantly focus on such issues, and the Task Force therefore recommends that
further review of the issues be taken by interested professional organiza-
tions, including the appropriate ABA entities.)45

With respect to audit committees, the ABA Task Force recommended these
corporate governance practices:

The board of directors should establish an audit committee, composed exclusively of
independent directors.
a. The audit committee should meet regularly outside the presence of any senior
executive officer.
b. The audit committee should be:
i. authorized to engage and remove the corporation™s outside auditor (or if
legally permissible, to recommend such engagement or removal to the
Board), and to determine the terms of the engagement of the outside auditor;
ii. authorized and afforded resources sufficient to engage independent ac-
counting and legal advisers when determined by the committee to be nec-
essary or appropriate; and



45
American Bar Association, Report of the American Bar Association Task Force on Corporate Re-
sponsibility (Chicago, ABA, 2003), pp. 31“33.
172 The Legal Position of the Audit Committee


iii. responsible for recommending or establishing policies relating to non-
audit services provided by the corporation™s outside auditor to the Corpo-
ration and other aspects of the Corporation™s relationship with the outside
auditor that may adversely affect that firm™s independence.
c. The resolution of the board of directors creating the committee should specify
whether the foregoing decisions are to be made exclusively by the audit com-
mittee, or (where legally permissible) by the full board of directors (or by the
independent directors) upon the recommendation of the committee.

Section 301 of the Sarbanes-Oxley Act of 2002 requires the SEC to adopt rules re-
quiring the national securities exchanges and national securities associations to adopt
listing standards providing, among other things, that (i) each member of the audit
committee be independent, (ii) the audit committee be “directly responsible for the
appointment, compensation, and oversight of the work of any registered public ac-
counting firm employed” by the company, and (iii) the audit committee have au-
thority to engage independent counsel and other advisers. On January 8, 2003 the
SEC proposed rules to implement these statutory requirements. (Proposed Exchange
Act rule 10A-3, at www.sec.gov/rules/proposed/34-47137.htm.)
The Sarbanes-Oxley Act (§201, adding Section 10A(h) of the Exchange Act) also re-
quires that public company auditing firms perform permitted non-audit services only
upon advance approval by the audit committee.
The listing standards prescribed by Section 301 of the Sarbanes-Oxley Act of 2002
appear to require that the board of directors delegate to the audit committee direct
and exclusive responsibility for the matters specified in the statute. The Task Forces™s
recommendations differ in that they would allow the full board of directors (or all of
the independent directors) to act on such matters, upon recommendation of the audit
committee acting pursuant to the recommended procedures. The Task Force prefers
this approach because of the potential benefits of information and insight that may
be gained from other independent directors and even from directors who do not meet
prevailing standards of independence.46



GUIDELINES FOR MINIMIZING LEGAL LIABILITY
Obviously, the audit directors wish to avoid potential legal liability. To achieve this
objective, the directors should conduct their activities in a manner above reproach.
As evidenced by the statutory laws and court cases, their posture is critically
important in the corporate environment. Hence they should not only exercise the
required standards of care and loyalty in their positions but foster the profession-
alism regarding their directorship.
To assist the members of the audit committee in minimizing their possible
legal liability, the following guidelines are provided. Such guidelines do not pur-
port to be all-inclusive and are not intended to preclude the insertion of additional
matters. Also, it should be noted that the guidelines are presented in view of the
oversight and advisory capacity of the committee.


46
Ibid., pp. 65“66.
Guidelines for Minimizing Legal Liability 173


Minimizing the Audit Committee™s Legal Liability: A Checklist
I. The Independent Auditors
A. Have we inquired about the qualifications of the personnel whom we
engaged in the audit?
1. Review the backgrounds of the executive partner and auditing
personnel.
2. Inquire about the auditing firm™s registration with the SEC practice
division of the AICPA.
3. Inquire about the CPA firm™s participation in the voluntary peer re-
view professional practice programs.
B. Have we reviewed their engagement letter?
The auditor™s engagement letter sets forth the nature and scope of the
audit engagement in order to avoid any misunderstanding between the
auditing firm and the client. This letter constitutes a contract regarding
the professional services of the CPA firm.
C. Is there evidence that the audit examination was properly planned, su-
pervised, and reviewed?
1. Inquire about the overall audit plan concerning the scope, conduct,
and timing of the audit examination.
2. Discuss the level of knowledge which is required for the corporation
and the industry.
3. Discuss the ratio of staff assistants to supervisors in connection with
the level of responsibilities for the audit.
4. Review or request an outline of the supervisory review procedures of
the staff assistant™s work and note any disagreements among the audit
personnel.
D. Does the corporate annual report contain a fair and meaningful presenta-
tion of the information concerning the financial statements, footnotes,
and supplementary information?
Significant changes in the external reporting practices of the corporation
should be discussed (e.g., departures from generally accepted accounting
principles, exceptions to the consistent application of accounting princi-
ples, and the alternative applications of generally accepted accounting
principles).
E. Have we reviewed the recommendations made in their management
letter to assure the auditors™ objectivity?
1. The management letter contains the auditors™ recommendations as a
result of their evaluation of the system of internal control. Any mat-
ters regarding the material weaknesses in the system of internal con-
trol should be discussed as well as full compliance with the
provisions of the Foreign Corrupt Practices Act.
2. Discuss the implementation of the recommendations in the current
and prior years™ management letters as well as causes of management

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