SEC and PCAOB on Audit Committees

Public company counsel and audit committee members should be aware of recent activity at the U.S. Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) that could lead to additional regulation of audit committee disclosure and to federal normative expectations for how audit committees and their members behave.

The SEC

On July 1, 2015, the SEC issued a concept release [1] soliciting public comment on the question of whether more information should be disclosed about the activities of public company audit committees. This new concept release is not a reaction to any particularly noteworthy development, nor is it responsive to a recent accounting scandal or a legislative directive. Rather, the SEC in its concept release notes:

• “the fact that a significant number of audit committees voluntarily provide information beyond the disclosures required by our current rules raises a question of whether there may be market demand for such information;” and
• “investors and other stakeholders have requested greater transparency about audit committee activities.”

For these reasons, the SEC seeks public comment on whether its disclosure requirements should be amended to elicit additional information about what audit committees do, because this information could be valuable in two respects. First, it could provide “useful context for audit committee decisions.” Second, it could “enable investors to differentiate between companies based on the quality of audit committee oversight, and determine whether such differences in quality of oversight may contribute to differences in performance or quality of financial reporting among companies.”

The concept release focuses on three topics: the audit committee’s oversight of the auditor, the audit committee’s process for selecting the auditor, and the audit committee’s consideration of the qualifications of the audit firm and certain members of the engagement team when selecting the audit firm. On their face, these topics are likely to be of interest to some investors. The difficulty for issuers and audit committees, however, is in the details. For example, the SEC asks whether there should be disclosure about how the audit committee:

• “dealt with disagreements between company management and the auditor;”
• “considered any deficiencies described in the PCAOB inspection report on the audit process;” and
• “evaluated the auditor’s objectivity and professional skepticism, as well as the results of such an evaluation.”

These potential areas of disclosure are qualitatively different from the disclosures required of audit committees to date in that they focus on the thought process of individual audit committee members in an open-ended context that leads to no definitive conclusion other than that the audit committee has decided that it has discharged its oversight duty. In other words, these disclosure requirements focus on the questions that the audit committee posed to the auditor, and the follow-up questions they asked in response to the answers they received.

The concept release acknowledges that a primary objective of these disclosures would be to “enable investors to differentiate between companies based on the quality of audit committee oversight, and determine whether such differences in quality of oversight may contribute to differences in performance or quality of financial reporting among companies.” Disclosing information so that shareholders can compare the quality of oversight between and among public companies sounds like a valid objective. However, given the unique circumstances that each company faces, it will be challenging to compare the quality of audit committee oversight separate and apart from these circumstances, as well as the fact that oversight is—in many instances—about subjective human judgments. Indeed, we question whether “quality of oversight” can be measured or evaluated in the abstract, based on responses to the hypothetical questions posed in the SEC’s concept release.

Another concern relates to the “Heisenberg Principle” effect: in physics, this means that the act of observation will itself change the phenomenon that is being observed. Here, a requirement to disclose how the audit committee dealt with disagreements between company management and the auditor may change the way in which management and the auditor inform the audit committee of such disagreements, as well as the manner in which the audit committee deals with any such disagreements. For example, if this disclosure is required, management and the auditor may be tempted to redefine whether and how an issue is classified as a “disagreement,” thereby potentially reducing audit committee insight into these issues. Should the audit committee recalibrate what constitutes a disagreement, this may lead to less rigorous discussions with the auditor and management. While requiring disclosure can be an effective way to change behavior, the potential for improvements in behavior must be balanced against the potential for unintended consequences, which could discourage candid discussion between and among management, the auditor and the audit committee. Without a compelling reason why this is necessary for public company audit committees, this risk alone should give the SEC reason to pause.

The potential chilling effect on audit committee decisions, deliberations and judgments will likely be a theme in the public comment that the SEC has invited. While this information may be of interest to investors who seek greater transparency into the committee room, it will also raise concerns that investors are being inundated with too much information—so much so that they often turn to third parties to digest the information and advise them on how to vote based on it. Should that be the result, then once in the hands of these third-party advisors, additional legitimate concerns arise regarding the one-size-fits-all nature of the policies the third-party advisors are likely to apply in making vote recommendations on related topics, including the election of audit committee members.

The PCAOB

Separately, in May 2015, the PCAOB issued its first Audit Committee Dialogue [2] which begins: “In our talks with audit committee members, we heard your request to provide insights from our oversight activities.” In this dialogue—as it has elsewhere—the PCAOB offers up possible questions that it would like audit committee members to ask auditors. When a regulator suggests questions that an audit committee should ask of its auditor, such a suggestion is difficult to ignore. The PCAOB’s suggested questions, combined with the requirements of the PCAOB’s Auditing Standard No. 16, “Communications with Audit Committees,” appear intended to influence the relationship of the audit committee and auditor and the dialogue between them. Auditing Standard No. 16 requires the auditor to communicate certain specific matters to the audit committee. In its “Potential Questions for Your Auditor,” the PCAOB has now provided audit committees with a suggested script for the audit committee’s side of that conversation.

Since the enactment of Sarbanes-Oxley, public company audit committees have been subject to a high degree of regulation, in terms of heightened independence requirements for audit committee members and enhanced responsibilities for audit committees as set forth in their charters. The audit firms they oversee are also subject to a high degree of regulation, in terms of both PCAOB audit standards and the PCAOB’s inspection process, which is annual for the largest audit firms. Given this existing federal regulatory regime, and the importance of respecting the traditional role of state law regulating the substance of director conduct and oversight, in our view, the case for more regulation—whether in the form of disclosure requirements or suggested questions for the audit committee to ask the auditor—has not yet been made. Under state law, particularly that of Delaware, boards and board committees are free to discharge their fiduciary duties, including how they communicate among themselves and with auditors, without the oversight of courts or administrative regulators.

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The SEC’s concept release and the PCAOB’s audit committee dialogue suggest, both directly and indirectly, that an unprecedented layer of federal regulation of how audit committee members should carry out their state law fiduciary duties would be appropriate, without demonstrating any countervailing upside benefit or justification. Given the potential significance of these regulatory developments, we highly recommend that counsel to public companies and audit committee members follow these developments closely and consider to what degree these efforts—even absent any definitive regulatory action—signal regulatory expectations about audit committee behavior.

Endnotes:

[1] SEC Release No. 33-9862, Possible Revisions to Audit Committee Disclosures (Jul. 1, 2015), available at http://www.sec.gov/rules/concept/2015/33-9862.pdf.
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[2] Public Company Accounting Oversight Board, Audit Committee Dialogue (May 2015), available at http://pcaobus.org/sites/digitalpublications/Documents/AuditCommitteeDialogue.pdf.
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