AUDIT COMMITTEES - THE AMERICAN EXPERIENCEBY

Philip A. Loomis, Jr.Commissioner

Securities and Exchange CommissionWashington, D. C.

The Institute of CharteredAccountants in Englandand Wales

Royal Lancaster HotelLondon, England

Evolution of the Board of Directors

While the evolution of the board of directors was,of course, closely related to the evolution of thebusiness corporation itself, I will not try to trace thelatter except for the basic outline in my synopsis.One major difference between the American experienceand the British should, however, be kept in mind.While corporation law in Great Britain has been laiddown in a series of Companies Acts of nationwidescope, corporation law in the United States isprimarily state law and the various states originallywent in rather different ways. Some viewed corporationswith some suspicion and sought to restrict them andto guard against abuse, while others were more liberal,or one might say, permissive. The evolution has beentowards the latter approach. This resulted, in largemeasure, from the fact that, under the federal constitution,a corporation established in one state can do businessin all the others, subject only to limited restrictions.Thus businessmen chose to incorporate in a state whosecorporation laws were to their liking and certain states,

The Securities and Exchange Commission, as a matter of policy,disclaims responsibility for any 9rivate pUblication or speechby any of its members or em?loyees. The views expressed hereare my own and do not necessarily reflect the views of theCommission or of my fellow Commissioners.

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originally New Jer~ey and later Delaware and Nevada,systematically sought to attract corporations from allover the country in order to collect the fees payable tothe state of incorporation. The courts held that,generally speaking, questions of corporation law wereto be governed by the law of the state of incorporation.

This development also resulted in a separation ofsecurities law from corporation law to a far greaterextent than exists in England. Our major securitiesmarkets are national in scope and, for that and otherreasons, much securities law is Federal not state and,even in the states, securities laws, unlike corporationlaws, were designed largely to protect investors fromdubious ventures, rather than to facilitate the develop-ment of business.

Turning now to the board of directors. State lawrequires that they be elected by the shareholders, butprovides wide latitude with respect to the size,composition and term of office of the board and itsmembers. The statutes traditionally have said thatthe business of the corporation "shall be managed bythe board of directors" and most still do, althoughthere is a recent tendency to say that the corporationshall be managed "under the direction" or the supervisionof the board.

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The traditional formula has, I think, meant differentthings at different times. In earlier periods, up to thebeginning of this century or somewhat later, the board waslargely composed of the principal officers and shareholdersof the corporation and, in that sense, the board did managethe com~any, or at least board members did. In the case ofsmall companies, this is still true. Later, with thedevelopment of very large corporations whose shares werewidely distributed among a great many small investors,although the formal structure of the board did not change,the underlying balance of forces was substantiallydifferent.

In large corporations, the numerous and unorganizedshareholders were neither able to exercise control normuch interested in doing so. They signed and returned theproxies sent to them by management. This meant thatmanagement selected the board members and, aside fromformal responsibilities required by law, largely determinedthe role of the board. The ?rimary function of the board,as such, came to be to advise and consult with managementon significant matters and board members were frequentlyselected on the basis of the gerceived value of theiradvice.

This was not a bad system; it facilitated decisionmaking and was conducive to efficiency. Much depended,however, on the competence and character of ~anagement,

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and the fact that the board was primarily advisoryclearly diverged from the concept that the board"manage" the company.

This structure of control with respect to largecorporations has come under increasinq criticism.Initially, this focused on the diminished role ofshareholders as owners of the company and upon thepossibility that the interests of shareholders wouldbe subordinated to the interests of management.One principal purpose of the federal securitieslaws was to provide safeguards for shareholdersin terms primarily of full disclosure, andregulation of the proxy solicitation process.While this concern for stockholder protection and,beyond that, for what is sometimes called "corporatedemocracy" is still very lively, a somewhat broaderconcern has become manifest in recent years. Itis suggested that management is not effectivelyaccountable to anyone and that the system of corporategovernance should be re-examined. Sone have suggestedfederal legislation, either requiring federal charteringof large corporations or, at least, the establishmentof federal minimum standards for corporate conduct.Naturally the corporate community does not favoradditional regulation or governmental involvementand the Commission, the corporate community and

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others are exploring alternatives. In that connection,the functioning of the board of directors is receivingconsiderable attention. While it seems to be generallyagreed that the board of directors cannot realisticallybe expected to "manage" a large corporation, it isbelieved that measures could be taken to make manage-ment more accountable to the board and to emphasizethe function of the board in monitoring the activitiesof the management.

The reasons I have discussed the evolution ofthe board of directors at some length is because Ibelieve that the creation and development of auditcommittees in United States corporations can onlybe understood in terms of the changing nature andfunction of the board itself.

History and Reasons for the Development ofAudit Committees

The origin of audit committees in the UnitedStates appears to be somewhat obscure. Somefinancial corporations, such as banks and insurancecompanies, have had audit committees for a longtime. This seems to have resulted from statuteswhich required the board of directors of suchcompanies to themselves conduct an audit.

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Aside fro;r:such special situations, auditcommittees are a relatively recent 1evelopment.General Motors Corporation, which has been somethingof a pioneer in the use of committees and in otheraspects of board structure, has had an auditcommitteee since 1939. The McKesson-Robbins scandalexposed in 1938, and the resulting investigation bythe Commission, resulten in a number of initiativesin the area of aUditing. As some of you may recall,the audited financial statements of ~cKesson-Robbinsfor 1937 reported total assets of $87 million, of whichsome $20 million of inventories and accounts receivableproved to be entirely fictitious, as were $18 millionin sales and $2 million in gross orofits. Top manage-ment conceived and executed this fraud over a periodof some ten years. ~mong the recommendations i~ theCommission's 1940 re90rt of its investigation was theestablishment of an audit committee of non-officerdirectors in order to further the independence ofaudItors. The New York Stock Exchange made a similarsuggestion at about the same time and the AmericanInstitute of Certified Public Accountants did sosomewhat later. Nevertheless the response wasInitially quite modest. ~ careful study made in1970 concluded that "interest in audit committees

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was not widespread and their use was not general." 11The 1970's, however, have seen a rapid growth ofinterest in audit committees and in their estab1ish-ment by the larger companies. A 1976 successorto the 1970 study ~/ reported that 87% of thecompanies surveyed had audit committees, 10% didnot, and 3% did not reply. More than half of thecompanies with audit committees had establishedthem in the last five years, that is, in the 1970's.In a memorandum recently filed with the Commissionby the Business Roundtable, it is stated that, ofnearly 900 companies reporting to the ConferenceBoard, a leading business organization, thepercentage having audit committees had risen to 90%in 1977, as compared to 24% in 1967 and 45% in 1972.

An important cause of the increased creation ofaudit committees has been the action of the New YorkStock Exchange and the Commission. In 1973 theExchange issued a so-called "White Paper" with respectto financial reporting to shareholders, including asection on audit committees, which said, amonq otherthings, "The Exchange believes that the idea no longer

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y

R. K. Mautz and F. L. Neumann, "Corporate AuditCommittees" (University of Illinois, 1970).R. I. Mautz and F. L. Neumann, "Corporate AuditCommittees, Policies and Practices (Cleveland,Ernst & Ernst, 1977).

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represents a corporate luxury but has become a necessity,and we strongly recommend that each listed company forman Audit Committee." In 1972, the Commission issued astatement reciting some of the developments withrespect to audit committees and endorsed the establish-ment of audit committees composed of non-managementdirectors by all publicly-held companies.

The initial reason for the establishment of auditcommittees appears to have been a desire to strengthenthe independence of auditors from management. TheCommission's 1940 proposal was based almost entirelyon this objective. The independence of auditors is afundamental concept, and independence is the principalreason why outside auditors are brouqht in at all,rather than simply using company accounting personnel.If the auditor is selected by a committee of independentdirectors, which also approves the audit program, andif the auditors can have recourse to such a committeein case of a serious disagreement with management,then their ability to function independently isclearly increased. The usefulness of an auditcommittee for these purposes depends in large parton the committee being composed wholly or primarily ofnon-management directors, and that has been a part of theconcept almost from the beginning. Consequently,

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the establishment of audit committees has gone hand-in-hand with the movement towards having a significantproportion of non-management directors on the board.

Another reason for the development of auditcommittees has been the change in the function of theboard of directors which I outlined earlier. As theboard moved from the function of actively managingthe company to the function of setting broad policyand examining how that policy is working and whetherit is being effectively carried out, the review andanalysis aspect of the board's work assumed increasingimportance. The function of the audit committee isprecisely to engage in such review and examination.Further, the audit committee, through its contactswith the auditors and otherwise, gathers informationwith respect to the financial condition andoperations of the company and thus provides anotherchannel by which information may come to the board.A frequent complaint of non-management directorsis that they may not get all the information theywould like to have from the reports made to theboard by management, so a separate channel can beuseful.

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The recent experience of the Commission and thebusiness community in the United States with what wascalled "improper or questionable payments," which oftenmeant bribes to government officials in foreigncountries, provides a striking example of thisindependent information gathering function. Thus,while I do not wish to dwell here on this controversialand unsavory matter, it does relate, to some extent, toaudit committees. Management, understandably, did notinclude such payments in their routine reports to theboard. They did not tell the auditor either, but,in some instances, auditors discovered suspiciouscircumstances. If the ~u~itors were able to bringtheir suspicions to an audit committee, the problemwas more likely to be discovered and dealt with thanif such a channel did not exist. When such problemswere uncovered, the au~it committee was oftenassigned the task of making at least the initialinquiry. Where no audit committee existed, one wasquite often created and given such an assignment.In settling enforcement cases in this area, theCommission has required the creation of auditcommittees as one of the means of preventing arecurrence of the improper practices. Generallythis episode has been a stimulus to the creation ofaudit committees and that is one of the few favorablethings one can say about it.

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I think another reason for audit committees isthe increasing emphasis on what is called internalcontrols. As corporations not only become larger butalso become more diversified, engaging in a varietyof different businesses and doing so in many differentcountries, it becomes more difficult for responsiblemanagement to keep track of what is going on in allthe various units and to make sure that managementpolicies and directions are being followed. Toaccomplish this, corporations have establishedsystems of internal accounting and other controlswhich are designed to require that transactions areexecuted in accordance with prescribed proceduresand that the acquisition and disposition of assetsis properly authorized and duly accounted for.In December 1977, as part of the Foreign CorruptPractices Act of 1977, Congress required all companiesregistered with the Commission, which includes almostall publicly-owned companies in the United States, tohave such a system of internal controls.

As an additional internal control, many companieshave created an internal auditing unit whose principalresponsibility is to see to it that the internal controlsystem is functioning properly. Generally, the internalauditors report to management and there is some

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uncertainty as to their relationship with the auditcommittee. Since, however, internal controls andinternal auditing relate to the accounting andauditing function, the audit committee isnecessarily involved and I believe that as auditcommittees develop, this will become increasinglyso.

In describing the history of audit committeesand the reasons why they have developed so rapidly inrecent years, I have referred to their function 3S acheck on management control, in such areas asincreasing the independence of the auditors, providinga separate channel of information to the board ofdirectors, and improving internal control, includingthe prevention and detection of improper practices.In so doing, I do not wish to leave the impressionthat the relationshi? between management and auditcommittees is, or should be, an adversary one.Obviously it should not, and the fact that a greatmany corporate managements have initiated or supportedthe creation of audit committees demonstrates that itis not so regarded. In the 1976 study I mentioned,only one out of some 250 chief executives questionedregarded the relationship as an adversary one.

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Present Requirements and Recommendations Relatingto Audit Committees

At the present time there are few, if any, legalrequirements with respect to audit committees. One reasonfor this is the fact that such committees have come intogeneral use only recently. Beyond that, as I mentioned,the law in the United States with respect to theorganization and structure of corporations is primarilystate law. I know of only one state, Connecticut,which has adopted any legislation with respect toaudit committees. Congress could, of course, adoptlegislation in this area but it has not done so.A subcommittee of the Senate Committee on GovernmentAffairs in a report issued in November of 1977, expressedthe view that publicly-owned corporations should be requiredto have audit committees composed of outside directorsbut relied on the accounting profession and the Commissionto accomplish this. Some Congressional committees willprobably revisit this subject in next year's session.

Consequently, the principal requirement now in effectis the Policy Statement of the New York Stock Exchange,adopted in 1977, that each domestic company whose commonstock is listed on the Exchange

"shall establish no later than June 30, 1978and maintain thereafter an Audit Committeecomposed solely of directors independent ofmanagement and free from any relationshipthat, in the opinion of its Board ofDirectors, would interfere with theexercise of independent judgment as acommittee member."

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The Exchange has provided guidelines to assist the companies'boards of directors in applying the policy that members ofthe audit committee be independent. Officers and employeesof the company or its subsidiaries are not eligible. Formerofficers may be, if the board determines that they areindependent. A connection of a director with an organizationwhich does business with the company is not necessarilydisqualifying, but service as a professional advisor,consultant, or legal counsel would be, if the boarddetermines that the relationship is material to any ofthe parties.

In 1974, the Commission amended its disclosurerequirements to call for a statement by reporting com?aniesas to whether or not they had an audit committee. In July1978, the Commission published for public comment proposedrules which would require considerably more disclosureconcerning committees of the board of directors. Indoing so, we encountered the same problem that appearsto have troubled the New York Stock Exchange, which isthat, although it is agreed that an audit committeeshould be composed of "independent" directors, there isno agreed upon definition of "independence." Directorsof a corporation may have a great variety of otherrelationships. They may be connected in one way or anotherwith other companies which are customers, suppliers, orbankers to the corporation, and these relationships may be

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important or they may not. Directors may be partnersof firms which provide professional services of onekind or another to the company or may be relatives insome degree of officers of the company. The Exchangein large measure leaves these questions to the fullboard of directors of the company. We can hardly dothat in a disclosure requirement, but I am notsatisfied that we have yet come up with an adequateanswer and I suspect that our proposed rules will bemodified before they are adopted.

Early this year, the American Institute of CertifiedPublic Accountants appointed a committee to examine thequestion of whether the Institute should require thatcompanies establish audit committees as a conditionof an audit by an independent public accountant, andif so, how this might be done. They considered suchquestions as to what companies such a requirementwould apply, whether to all public companies, or toonly those registered with the Commission, of whichthere are about 11,000, or only to the larger ones.They also considered the composition of the committeeand its functions. If the Institute were to requireaudit committees, it was suggested that this could bedone by requiring, either as an ethical rule or anauditing standard, that a certified public accountantrefuse to give an 09inion if the client did not have

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an audit committee or that he would have to so qualifyhis opinion. A public hearing was held by the Institutein Chicago early in June. I understand that at thehearing the proposal was received rather coldly, therebeing a good many objections. The Institute has made noannouncement as to its decisions, but I am told that itis unlikely to adopt the proposal, at least at thistime.

The Relationship of Audit Committees to the Boardof Directors, Management, Auditors and Stockholders

The final item of my agenda, the relationship ofthe audit committee to the board of directors, management,auditors and stockholders is difficult to deal withbecause the general use of audit committees is quiterecent. There are no definitive standards or rulesgoverning such committees and the companies involvedvary greatly, not only in size, but also in theirmanagement structure and operating style, as well asin the reasons which have led them to create an auditcommittee in the first 9lace. At least prior to therecent Exchange requirement, the decision whether tohave an audit committee or not rested with eachindividual company and the company, consequently, hasconsiderable freedom to determine the functions andrelationships of the committee.

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The 1976 survey which I mentioned earlier found, notsurprisingly, that the functions of audit committees tendto evolve with experience. When the committee is firstestablished, its assignment is relatively modest. Itwould nominate or approve independent auditors, receiveand review their reports and perhaps have some otherfunctions. As the committee evolves, it developsa closer relationship with the auditors, meets withthem more often, and considers such things as thescope of the audit and any problems encountered, andmoves beyond the annual audit to become increasinglyinvolved with such matters as the existence andfunctioning of the system of internal controls andinternal aUditing.

Thus in discussing the relationship of the auditcommittee to other organs of the corporation, such asthe board, the management, and the shareholders, I amaddressing a moving target since this depends upon theevolution of the audit committee itself, which inturn, is at different stages in different companies.Few generalizations are valid under these circumstances.

The relationship of the audit committee to theboard is fairly simple. It is one of the board'scommittees, assigned to a particular area. It willexamine the matters entrusted to it and makerecommendations to the board. It also serves as a

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separate channel by which information is communicatedto the board. ~s the committee develops, increasedresponsibilities may be delegated to it, particularlywith respect to relations with the auditors. There isan increasing tendency for the audit committee to becomposed entirely of non-management directors sincethis facilitates its function of strengthening theindependence of the auditors in relation to management.

Membership on the audit committee affords tonon-management directors an o?portunity to consulttogether and to gather information. Some believe thatthese characteristics of an audit committee will assistthe board and particularly the non-management directorsin becoming better informed and in taking necessaryactions and thus, hopefully, will reduce the possibilitythat board members will be subject to liability basedon charges that they failed to discharge theirresponsibilities to be aware of the corporation'scondition and activities. If problems develop, asillustrated by the improper payments situations, theaudit committee may be designated by the board to makean investigation and to report to the full board.This has been ~one not only in the questionable paymentsarea but in other situations when improper conduct on thepart of management is suspected.

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The relationship of the audit committee tomanagement is somewhat ambivalent. ~ccording to the 1976

survey, the audit committee was viewed as primarily anadvisor to management, which is consistent with theadvisory function of the board itself which I referredto earlier. But the survey indicated that the committeewas also thought of as a critic of management wheneverit felt that critricism was called for. This isconsistent with the concept of the board as having aresponsibility to monitor the activities of managementand the belief that the accountability of management tothe board should be strengthened.

This theme of the need for accountability has runthrough a great deal of the recent discussion of cor90ratestructure and corporate governance in the United States,as I understand it has in Great Britain, although witha somewhat different focus. I have the impression thatthe British concern has been somewhat broader in scope,embracing the relationship of the corporation tosociety as a whole and to employees in particular. Thathas not developed to any significant extent in theUnited States, partially because American labor unionsseem reluctant to become involved in questions ofcorporate governance, for fear that this would com9romisetheir position in arms-length bargaining. There is alsomore resistance in the United States to the idea of

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involving the government in issues of corporate governanceand accountability. Nevertheless, there is a growingbelief in the United Staes that management must beaccountable to someone. Legally management isaccountable to shareholders but, in large publiccorporations, this is attenuated in practice becausethe shareholders are a large and amorphous body manyof whom regard their holdings as merely an investment.They follow what has been referred to as the "WallStreet Rule," -- if you are dissatisfied with management,sell the stock. Of course, if enough shareholders feelthat way, the stock goes down and management may bein trouble. Furthermore, shareholders do have the rightto go to court and they do so far more frequently than Iunderstand to be the practice in Great Britain, particularlyby the use of "class actions" brought by one or moreshareholders on behalf of the whole shareholder body.This, however, is a remedy which can usefully beemployed only when illegal or clearly improper conductcan be proven, and thus does not provide for continuingaccountability. Consequently, if one does not chooseto bring the Government into corporate accountabilitybeyond that already provided for in the federalsecurities laws, and if the shareholders are notsufficiently involved, then one must look to the boardand this is what I think is happening.

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The audit committee is well situated to play animportant role in providing this accountability becauseit is composed of non-management directors, has a specialrelationship with the outside auditors, and necessarilyconcerns itself with the functioning of the corporation'saccounting system and its system of internal controls.The new statutory requirement that cor90rations reportingto the Commission must have a system of internal accountingcontrols meeting specified standards as well as adequatebooks, records and accounts may be expected to emphasizethis concern, since the audit committee is the logicalbody to make sure on behalf of the board that this newlegal obligation is com9lied with.

The relationship between the audit committee andmanagement will, of course, vary from company to company,but the concept appears to be that while the relationshould be one of cooperation in the interest of thecompany, there is a certain tension by reason of thecommittee's monitoring functions and its participationin the process of furthering management accountability.

The relation between the auditor and the auditcommittee is necessarily a close one if the auditcommittee has developed to the extent that it has asignificant function in the company. As I mentioned,one of the principal reasons for creating auditcommittees was to enhance the independence of the

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auditor from management. Management, rather than theboard as such, has the responsibility to ~eep books ofaccount and to prepare financial statements. If t~esestatements are to be examined by an "independent"auditor as the federal securities laws require, thatauditor must be Lndependent of the management whosestatements it audits.

I understand that in england the auditors areregarded as res?onsible to the shareholders not tomanagement. This has not been so clear in theUnited States. The corporation statutes are usuallysilent on the point. Management has traditionallyselected the auditor, although his a~pointmentmight require formal ap?roval by the board. Theauditor's contacts in the course of their workwere with representatives of management. Theconcept of auditors be~ng responsible to shareholdershas, however, been recently gaini~g ground. TheCommission suggested in 1940 that the a?pointmentof auditors be submitted to stockholders at the annualmeeting and this is now quite generally done. ItssignifIcance is more symbolic than anything elsesince shareholders of large 9ub1ic corporations do notparticipate in the selection process, but it mayinfluence the auditor's conception of his res?onsibility.So also the auditors may be subject to suit by stock-holders for breach of duty. The existence, however,

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of some uncertainty as to who the auditor isresponsible to may have contributed to the needfor audit committees and other measures to strengthenthe independence of the auditors.

The characteristics of the audit committee whichare designed to further the independence of theauditor, which I outlined earlier, also enable theauditor and the audit committee to work together tothe advantage of both and that is one reason whythe accounting profession in the United Stateshas rather consistently over the years advocated andsupported the creation of audit committees.

The relation between the audit committee andthe internal auditor is less clear and more difficult.

Internal auditors are also a rather recentdevelopment. They have been thought of as responsibleto, or even as a part of, management, their functionbeing to see that management instructions are compliedwith. Yet it seems to be recognized that internal

auditors should, at least, be indegendent of theoperating personnel whose activities they audit.Outside auditors place some, ?erhaos considerable,reliance on their work, and audit committees may welldo the same. The recent legislation with respect tointernal controls seems likely to increase thesignificance of the internal auditors function,

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particularly when this legislation is fully implemented.Internal auditors themselves seem to feel a need formore independence, if not from top management, at leastfrom lower level management. It seems to me that theinternal audit function will necessarily be a matterof interest and concern to a fully functioning auditcommittee and this concern may bring about more corporatestature for that activity. But the internal auditorswill probably continue to be responsible to managementbut increasingly that will be top management and theaudit committee will be involved.

In these remarks I have endeavored to describethe American experience with audit committees, sincethat was my assignment. While I have ventured on someforecasts as to how I think the audit committee willevolve, I have not expressed any conclusions as towhether all this is worthwhile and desirable. In aword, I think it is. I have a few other closingobservations.

1. Not every corporation or even everycorporation reporting to the Commission needsan audit committee. There is no olace for anaudit committee unless the company has non-management directors to serve on it. Evenwhere there are such directors, it may wellbe possible in small corporations for the

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full board to perform this function. Anaudit committee should not be created unlessthe board and the management are willing togive it a job to no. Otherwise you have afacade which may be misleading.

2. Because of the differences amongcompanies, it is not, at least at this time,feasable to have a standardized and universalmodel for audit committees. They will bedifferent, although certain principles, suchas the com90sition of the audit committee,are basic. Further, there is still a gooddeal of defining to do. For example, whatrelations with management disqualify adirector from service on the audit committee?What are its relationships with the internalauditor?

3. Audit committees have develooed, atleast in part, in resoonse to a felt need tostrengthen the accountability of largecor90rations an~ their manage~ent to theirvarious constituencies. Large corporationsgerform an essential economic function andthey must be free to oerform it effectively.At the saroe time they ~ave considerablepower, and power in a free society must be

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accompanied by accountability. The fact thatmost large cor?orations have voluntarilycreated audit committees is evidence of awillingness on their part to make necessarychanges. To the extent that they makechanges voluntarily, the need for moredrastic governmental intervention is avoided.We have a great deal of government interventionin business in the United States now, quitepossibly too much, and I certainly hopethat we will not have to have more of it.