When Should an Audit Committee Consider Independent Counsel?

Reporting companies, of course, typically engage outside counsel to assist them in complying with their responsibilities under the federal securities laws, state corporation laws and the numerous other federal and state laws applicable to the business and administration of a publicly held company. Many of these companies also employ in-house counsel familiar with securities and/or corporate issues. Given the significant expense and potential duplication of effort, many issuers are encouraging their audit committees to rely upon the company's regular outside counsel and/or in-house counsel for legal advice.

Reasons for Independent Counsel

In many instances, the interests of a company and its audit committee coincide, and it may be reasonable and prudent for the audit committee to rely upon regular outside counsel and/or in-house counsel for legal advice. But there are circumstances in which law, principles of professional responsibility or prudent practice dictate that the audit committee ought to have independent counsel. The following are some of the circumstances in which an audit committee should consider engaging its own, independent counsel.

Adoption of New Policies

The Sarbanes-Oxley Act and the rules proposed by the stock exchanges or Nasdaq require that the audit committee adopt a number of policies and procedures. In particular, an audit committee requires a detailed charter specifying its responsibilities and procedures for supervising the accounting, auditing and reporting process (including resolution of disagreements between management and the auditor regarding financial reporting), as well as policies for approving audit and non-audit services, policies for establishing, implementing and testing internal controls, policies for handling complaints regarding accounting, internal controls and auditing matters and policies for handling reports of potential material violations of securities law or fiduciary duties under the SEC's new professional responsibility rules (so-called “up-the-ladder” reporting).

Each of these policies involves a degree of supervision of management, and the committee and management may differ as to the manner and degree of supervision that is required. Accordingly, regular counsel, who are likely to work with management in connection with these supervised activities, may be subject to a conflict if they assist the committee in preparing these policies. Independent counsel could assist in the preparation of these policies without reservations about subjecting management to policies more onerous than management might desire.

Disagreement with Accountant

The audit committee is charged with resolving disagreements between management and the accountant regarding financial reporting. Although regular outside counsel and/or in-house counsel sometimes have been called upon, in effect, to mediate these disagreements, regular counsel is often asked to advocate management's positions with the accountant, such as in discussions with the accountant's national office. Engaging regular counsel to advise the committee on such a disagreement would deprive management of the assistance and advocacy of their regular counsel on an uncertain accounting issue or could place regular counsel in a hopelessly conflicting position, attempting to advise both management and the committee in connection with understanding and resolving the disagreement.

Whistleblower and 'Up-The-Ladder' Reporting

The audit committee is charged with receiving complaints concerning auditing and accounting and also may receive “up-the-ladder” reports from counsel. The committee will be required to evaluate such complaints or reports and determine whether further investigation is warranted. The committee is almost certain to require the assistance of counsel in connection with such matters, which are likely to involve allegations of violations of accounting rules and may involve allegations of violations of law. Regular counsel may face numerous potential conflicts in connection with these matters. For example, the matter may involve allegations with respect to executives who the regular counsel routinely advises and might even involve matters with respect to which regular counsel provided advice. Even if there is no direct conflict, regular counsel would have a conflict to the extent that the interests of the committee and the interests of the company (or management) may differ. For example, if the audit committee receives a complaint that does not conceal the identity of the whistle-blower but requests confidentiality, could regular counsel withhold the identity of the complainant from management? Even if regular counsel can avoid technical conflicts, the audit committee must also consider whether engaging independent counsel adds credibility to internal investigations. Employees may be more likely to cooperate with an investigation that appears to be independent than an investigation that is conducted by the same counsel that regularly advises management.

Approval of Independent Committee

Under state corporation laws, transactions in which members of the board of directors have a personal interest will more readily withstand judicial scrutiny if they are approved by an “independent committee.” The audit committee, because it is required by the Act and stock exchange and/or Nasdaq rules to be composed entirely of independent directors, may be called upon to serve in this role. However, under state corporation laws, even if the individual directors are “independent,” the committee may not qualify if its independence is otherwise compromised. For example, Delaware courts held that a committee was not independent when the committee employed an adviser who had a material relationship with an interested party or even when the committee engaged without question an adviser recommended by an interested party.

Related Party Transactions

Many related party transactions, because they only involve one director or one officer, may not require the approval of an independent committee or other special handling from the point of view of fiduciary obligations. However, to the extent that a transaction involves a member of senior management, regular counsel may be placed in an awkward position. Regular counsel may hesitate to raise difficult issues when advising the audit committee with respect to a related party transaction involving an officer that the counsel otherwise regularly advises as a member of management.

Practical Considerations

For the many audit committees that will not obtain the continuous assistance of independent counsel, how can the committee best obtain independent counsel, taking into account both the committee's need for effective legal advice and the costs involved? The committee should consider engaging independent counsel in advance of a critical need so that they may have the benefits of:

• having an independent counsel that is generally familiar with the company, its business and its principal accounting and reporting issues before or she is asked to assist on an urgent problem;
• the committee's counsel becoming a familiar, if not frequent, participant in the consideration of audit committee matters so that the consultation of committee counsel does not appear to indicate that a crisis looms;
• the committee members working with and becoming familiar with their counsel, particularly as they begin the process of dealing with their new and expanded responsibilities, so that that committee counsel will be a trusted resource if and when the audit committee members are placed “on the spot.” Further, independent audit committee counsel may be viewed by underwriters of directors and officers insurance as a significant element of “preventative” corporate governance and may help facilitate obtaining or renewing coverage and/or mitigating premium increases.

Conclusion

In view of the numerous new responsibilities imposed on audit committees, every public company audit committee will require some advice of counsel in establishing new policies and procedures and understanding its expanded responsibilities. Although much advice may be provided by the issuer's regular outside or in-house counsel, a number of circumstances, based upon legal requirements, professional responsibilities or prudent practices, suggest that the advice of independent counsel is desirable. Audit committee members and regular counsel should be sensitive to these circumstances, and the audit committee should engage independent counsel when appropriate. Finally, because almost any audit committee will eventually require some assistance of outside counsel, audit committee members should consider the benefits of engaging independent counsel before they are urgently required in order to permit independent counsel to become familiar with the company's business and its principal accounting and reporting issues.

As widely reported and discussed since July 2002, the Sarbanes-Oxley Act of 2002 (the Act) imposes a substantial number of new responsibilities on the audit committee of a public company required to file periodic reports under the Securities Exchange Act. These responsibilities include:

• appointing the company's registered public accountant, determining his or her compensation and overseeing his or her work (including resolution of disagreements between management and the accountant regarding financial reporting);
• approving the receipt of audit and non-audit services from the accountant;
• receiving the accountant's report on critical accounting policies and practices and alternative treatments of financial information discussed with management;
• receiving complaints regarding accounting, internal controls and auditing matters; and
• receiving reports of counsel of evidence of a material violation of securities law or breach of fiduciary duty.

The audit committee is also expected to oversee management's performance of a number of new responsibilities under the Act, including participating in the preparation of, and certifying the accuracy of, periodic reports and establishing, maintaining and assessing the effectiveness of internal controls. Further, at least under the proposed revised Nasdaq listing rules, the audit committee will be required to review and approve related-party transactions.

Need for Audit Committee Counsel

In view of the numerous new responsibilities imposed directly on audit committees, audit committee members are likely to desire the assistance of counsel to help them understand and comply with these requirements. Indeed, Section 301 of the Act expressly mandates that, as a condition of listing on a stock exchange or Nasdaq, an issuer must grant its audit committee authority to engage independent counsel and other advisers, as the committee determines necessary to carry out its duties, and provide for appropriate funding, as determined by the committee, for payment of compensation to such advisers.

Reporting companies, of course, typically engage outside counsel to assist them in complying with their responsibilities under the federal securities laws, state corporation laws and the numerous other federal and state laws applicable to the business and administration of a publicly held company. Many of these companies also employ in-house counsel familiar with securities and/or corporate issues. Given the significant expense and potential duplication of effort, many issuers are encouraging their audit committees to rely upon the company's regular outside counsel and/or in-house counsel for legal advice.

Reasons for Independent Counsel

In many instances, the interests of a company and its audit committee coincide, and it may be reasonable and prudent for the audit committee to rely upon regular outside counsel and/or in-house counsel for legal advice. But there are circumstances in which law, principles of professional responsibility or prudent practice dictate that the audit committee ought to have independent counsel. The following are some of the circumstances in which an audit committee should consider engaging its own, independent counsel.

Adoption of New Policies

The Sarbanes-Oxley Act and the rules proposed by the stock exchanges or Nasdaq require that the audit committee adopt a number of policies and procedures. In particular, an audit committee requires a detailed charter specifying its responsibilities and procedures for supervising the accounting, auditing and reporting process (including resolution of disagreements between management and the auditor regarding financial reporting), as well as policies for approving audit and non-audit services, policies for establishing, implementing and testing internal controls, policies for handling complaints regarding accounting, internal controls and auditing matters and policies for handling reports of potential material violations of securities law or fiduciary duties under the SEC's new professional responsibility rules (so-called “up-the-ladder” reporting).

Each of these policies involves a degree of supervision of management, and the committee and management may differ as to the manner and degree of supervision that is required. Accordingly, regular counsel, who are likely to work with management in connection with these supervised activities, may be subject to a conflict if they assist the committee in preparing these policies. Independent counsel could assist in the preparation of these policies without reservations about subjecting management to policies more onerous than management might desire.

Disagreement with Accountant

The audit committee is charged with resolving disagreements between management and the accountant regarding financial reporting. Although regular outside counsel and/or in-house counsel sometimes have been called upon, in effect, to mediate these disagreements, regular counsel is often asked to advocate management's positions with the accountant, such as in discussions with the accountant's national office. Engaging regular counsel to advise the committee on such a disagreement would deprive management of the assistance and advocacy of their regular counsel on an uncertain accounting issue or could place regular counsel in a hopelessly conflicting position, attempting to advise both management and the committee in connection with understanding and resolving the disagreement.

Whistleblower and 'Up-The-Ladder' Reporting

The audit committee is charged with receiving complaints concerning auditing and accounting and also may receive “up-the-ladder” reports from counsel. The committee will be required to evaluate such complaints or reports and determine whether further investigation is warranted. The committee is almost certain to require the assistance of counsel in connection with such matters, which are likely to involve allegations of violations of accounting rules and may involve allegations of violations of law. Regular counsel may face numerous potential conflicts in connection with these matters. For example, the matter may involve allegations with respect to executives who the regular counsel routinely advises and might even involve matters with respect to which regular counsel provided advice. Even if there is no direct conflict, regular counsel would have a conflict to the extent that the interests of the committee and the interests of the company (or management) may differ. For example, if the audit committee receives a complaint that does not conceal the identity of the whistle-blower but requests confidentiality, could regular counsel withhold the identity of the complainant from management? Even if regular counsel can avoid technical conflicts, the audit committee must also consider whether engaging independent counsel adds credibility to internal investigations. Employees may be more likely to cooperate with an investigation that appears to be independent than an investigation that is conducted by the same counsel that regularly advises management.

Approval of Independent Committee

Under state corporation laws, transactions in which members of the board of directors have a personal interest will more readily withstand judicial scrutiny if they are approved by an “independent committee.” The audit committee, because it is required by the Act and stock exchange and/or Nasdaq rules to be composed entirely of independent directors, may be called upon to serve in this role. However, under state corporation laws, even if the individual directors are “independent,” the committee may not qualify if its independence is otherwise compromised. For example, Delaware courts held that a committee was not independent when the committee employed an adviser who had a material relationship with an interested party or even when the committee engaged without question an adviser recommended by an interested party.

Related Party Transactions

Many related party transactions, because they only involve one director or one officer, may not require the approval of an independent committee or other special handling from the point of view of fiduciary obligations. However, to the extent that a transaction involves a member of senior management, regular counsel may be placed in an awkward position. Regular counsel may hesitate to raise difficult issues when advising the audit committee with respect to a related party transaction involving an officer that the counsel otherwise regularly advises as a member of management.

Practical Considerations

For the many audit committees that will not obtain the continuous assistance of independent counsel, how can the committee best obtain independent counsel, taking into account both the committee's need for effective legal advice and the costs involved? The committee should consider engaging independent counsel in advance of a critical need so that they may have the benefits of:

• having an independent counsel that is generally familiar with the company, its business and its principal accounting and reporting issues before or she is asked to assist on an urgent problem;
• the committee's counsel becoming a familiar, if not frequent, participant in the consideration of audit committee matters so that the consultation of committee counsel does not appear to indicate that a crisis looms;
• the committee members working with and becoming familiar with their counsel, particularly as they begin the process of dealing with their new and expanded responsibilities, so that that committee counsel will be a trusted resource if and when the audit committee members are placed “on the spot.” Further, independent audit committee counsel may be viewed by underwriters of directors and officers insurance as a significant element of “preventative” corporate governance and may help facilitate obtaining or renewing coverage and/or mitigating premium increases.

Conclusion

In view of the numerous new responsibilities imposed on audit committees, every public company audit committee will require some advice of counsel in establishing new policies and procedures and understanding its expanded responsibilities. Although much advice may be provided by the issuer's regular outside or in-house counsel, a number of circumstances, based upon legal requirements, professional responsibilities or prudent practices, suggest that the advice of independent counsel is desirable. Audit committee members and regular counsel should be sensitive to these circumstances, and the audit committee should engage independent counsel when appropriate. Finally, because almost any audit committee will eventually require some assistance of outside counsel, audit committee members should consider the benefits of engaging independent counsel before they are urgently required in order to permit independent counsel to become familiar with the company's business and its principal accounting and reporting issues.