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AUDIT COMMITTEE RESPONSIBILITIES IN THE POST-ENRON ERA

MAY 13, 2002

In the wake of Enron’s collapse, well-publicized accounting problems at Waste Management,Global Crossing and other companies and a resulting loss of billions of dollars of shareholdervalue, financial reporting and the Audit Committee are in the spotlight like never before. Overthe past several months, President Bush, Congress, the Securities and Exchange Commission(the "SEC"), the Public Oversight Board and institutional investors have all called for sweepingreforms of the financial reporting process. This atmosphere has given many Audit Committeescause for introspection as they ask what they can and should be doing differently to fulfill theirrole as monitors of the corporation’s financial reporting process. Currently, every aspect ofAudit Committee conduct is subject to analysis.

The primary responsibility of the Audit Committee is to oversee the corporation’s financialreporting process on behalf of the Board of Directors and to report the results of their activitiesto the Board. The Board of Directors is responsible for properly constituting and monitoringthe Audit Committee. Where the Audit Committee is confronted with a particularly sensitiveissue, it should consider whether to present that issue to the full Board of Directors for itsconsideration.

What follows are our suggestions for how Audit Committees should address some of the mostimportant issues confronting them. We begin by discussing some of the substantive concernson which Audit Committee members should be focusing particular attention. We then considerpractical changes that may be appropriate to improve the Audit Committee’s review of thecorporation’s financial reporting process and presentation. Finally, we conclude with someobservations on the legal standards that apply to Audit Committee members in the performanceof their duties and suggest ways in which Audit Committee members can best fulfill theirresponsibilities and concomitantly reduce their exposure.

MMaayy 220000221 © 2002 Pillsbury Winthrop LLP. All Rights Reserved.

CURRENT ISSUES IN LIGHT OF ENRON

ISSUES REQUIRING SPECIAL ATTENTION

Many Audit Committee members are asking what caused Enron to implode and are concernedabout similar problems at their own companies. Because many of the accounting issuesinvolved in Enron’s demise are specific to Enron, Audit Committee members should instead befocusing on issues relevant to their own companies. Nonetheless, the uproar regarding Enronhas already provoked substantial actions by the SEC to expand financially-related disclosurerequirements and many of these affect the Audit Committee.

• RELATED PARTY AND SIMILAR TRANSACTIONS

Audit Committees should review transactions between the corporation and relatedparties–not only were they central to Enron’s collapse, they are also important for everycompany. At Enron, the company is alleged to have engaged in related party transactions thatenriched Enron executives and were without legitimate economic substance, transactions thatmost likely could not and would not have been done at arms-length. This is the area wherethe Powers Report (the Report of the Special Investigative Committee of the Board of Enron,chaired by William C. Powers, Jr.) most harshly criticized Enron’s Board and AuditCommittee for failing to engage in adequate oversight—at least twice the company waivedits Code of Conduct allowing the company’s CFO to run a partnership that bought and soldassets to and from Enron, and yet, after doing so, controls proved insufficient and the Boardfailed to adequately review their implementation.

Perhaps as a result, the SEC recently has singled out related (and "almost related") partytransactions for particular attention in the Management’s Discussion & Analysis section ofquarterly and annual reports ("MD&A"). In a January 2002 release, the SEC specificallystated that before the Audit Committee recommends that the financial statements be includedin the 10-K it should consider performing a review of these relationships in its discussionswith management and the auditors, including a review of their terms and the internalcorporate and ethical compliance decisions relating to the transactions.

The SEC has also suggested that the Audit Committee should take an expansive view of themeaning of "related party" rather than merely considering those relationships required to bedisclosed under SEC or accounting rules. In fact, recent press allegations thattelecommunications companies have used swaps to inflate their revenues suggest that theAudit Committee should consider all transactions in which the corporation engages that areon terms that would be unavailable from other, more clearly independent, parties, especiallywhen they affect a key financial metric of the corporation. In addition, the Board (or theBoard Committee which has the primary responsibility in those areas, which may be theAudit Committee) should review the company’s Code of Conduct or other conflict of interestpolicy, both to ensure that it is current and to assure themselves that adequate procedures existfor monitoring compliance.


• OFF-BALANCE SHEET TRANSACTIONS

Another spillover from Enron is the increased attention from the SEC and investors to off-balance sheet financing arrangements. At Enron, it is said that off-balance sheet transactionsallowed the company to obscure its ultimate financial obligations in a maze of unconsolidatedaffiliates. Although their revelation was enough to destroy the company’s credit andcredibility, the company’s financial reports never exposed the purpose and extent of thesedealings to even the most diligent observers.

Many companies engage in some form of off-balance sheet transactions, most of which areperfectly appropriate. However, we would recommend that the Audit Committee inquire ofmanagement and the auditors as to the details of any such transactions that could be materialto the company or to its perception by the financial markets. For those companies that doengage in significant or complex off-balance sheet transactions, the SEC is now seekingenhanced disclosure about the business purposes and activities, economic substance, keyterms and conditions, and potential risk exposures associated with them. Althoughmanagement bears the brunt of the disclosure obligation, Audit Committee members shouldbe asking about any such activities, their accounting treatment and how that treatment affectsreported results. Where these activities have a significant impact on the company’s business,Audit Committee members should be comfortable that the company’s disclosures in itsfinancial statements and reports are adequate and clear to the reader.

• CRITICAL ACCOUNTING POLICIES (ESTIMATES AND JUDGEMENTS)In December 2001, the SEC announced its intention to issue rules on the disclosure of "CriticalAccounting Policies"—really a misnomer for the four or five judgments and estimates that areboth most important to the portrayal of the company’s financial condition and results and thatrequire management’s most difficult, subjective or complex judgments. The SEC stronglyencouraged companies to include a discussion of Critical Accounting Policies in their currentMD&A disclosure and suggested that such disclosure include the judgments and uncertaintiesaffecting the application of those policies and the likelihood that materially different results wouldbe reported under different conditions or using different assumptions. On May 10, 2002, the SECthen issued proposed rules on this topic that would encompass MD&A disclosure in two areas:accounting estimates a company makes in applying its accounting policies, and the initial adoptionby a company of an accounting policy that has a material impact on its financial position.

In addition, the SEC’s proposal not only indicates that Audit Committees should be involved inthe review of the selection, application and disclosure of these critical accounting estimates, butwould require disclosure in the MD&A as to whether or not senior management has engaged indiscussions with the Audit Committee about them and, if not, why not? Audit Committeemembers should strive to understand how the principles underlying these estimates and judgmentsare developed and applied and how they affect reported results. To that end, Audit Committeemembers should be discussing these policies with auditors and with management to make sure thatthey are comfortable with the way that management has developed, applied and disclosed thesepolicies. In these discussions, it may be appropriate to ask for numerical applications of differenttreatments so that the Audit Committee can understand the effect of different assumptions on thecurrent financial statements and, just as important, trends for future performance.


• LIQUIDITY, CAPITAL RESOURCES AND RISK AND GAAP VS. FAIR PRESENTATION

Although the SEC has not given Audit Committees direct instruction on the subject, a January2002 release emphasized the importance of useful and understandable disclosure regardingliquidity and capital resources in MD&A. The SEC suggested that management describe itssources of short-term funding and the circumstances reasonably likely to affect those sourcesof liquidity, such as circumstances that might trigger early repayment or impair thecorporation’s ability to engage in transactions that have been integral to the historicaloperations of the corporation (this problem, of course, happened in Enron). Again, althoughmanagement is primarily responsible for preparing MD&A, the disclosures that MD&Acontains are supposed to illuminate the financial statements and, as such, liquidity and capitalresources disclosures require the Audit Committee’s attention.

In conjunction with the above review, Audit Committees should consider the key areas offinancial (and, to the extent it has an effect on the company’s financial statements, business)risk to which the corporation is exposed and the techniques that management uses to controlsuch risks. While financial statements are historical in nature, the Audit Committee shouldtry to ensure that the disclosures that accompany the financial statements tell the reader notonly what has happened at the company, but also what is reasonably likely to change.Companies need to make sure that they have an effective process for identifying andevaluating material risks to the company’s business and that such risks are plainly disclosedto investors. To the extent that other committees of the Board of Directors are responsible formonitoring risk management, the Audit Committee should receive regular reports on thesubject.

Finally, Audit Committees should consider not just whether the company’s application ofaccounting principles is technically correct, but also whether it truly presents a fair picture ofthe company’s financial condition—including the quality of the company’s earnings. SeniorSEC officials have recently indicated that, in their view, companies can comply withgenerally accepted accounting principles ("GAAP") and still violate the securities laws. Theyhave suggested that after a company has initially concluded that its financial statementsconform with GAAP, it should apply two more tests: (1) Does the overall result violate theaccounting principles upon which the relevant accounting rule is based?; and (2) Does theresult have the potential to mislead investors as to a material issue? If so, the company shouldconsider additional corrective disclosure.

AUDITOR REVIEW AND RETENTION

The retention and review of a company’s external and internal auditors is another process thatAudit Committees should be rethinking. Stock market rules require that the Audit Committee(or the Audit Committee together with the Board of Directors) be ultimately responsible forselecting the company’s external auditors. This is an important safeguard, but in any event it isessential that external auditors understand that they answer to the Audit Committee and theBoard of Directors and not to management. The Audit Committee should also demand similaraccountability from internal auditors.


• EVALUATION OF EXTERNAL AND INTERNAL AUDITORS

In evaluating the corporation’s external and internal auditors, the Audit Committee shouldconsider its impressions of the audit team’s responsiveness, candor and professionalism,placing particular emphasis on the character and abilities of the engagement partner and thesenior audit manager and the chief internal auditor. The Audit Committee should also reviewthe qualifications of the audit team, their experience in the company’s field of business andknowledge of the company. In addition, the Audit Committee may wish to consider theexternal audit team’s access to relevant technical expertise from the auditor’s home office, theresults of the auditor’s most recent peer review and the external auditor’s quality controlprocesses. The Audit Committee might also give consideration to whether the scope and costof the external auditor’s proposed audit is appropriate in light of the requirements at theirparticular company.

• PERFORMANCE OF NON-AUDIT SERVICES

Another issue that Audit Committees should be reviewing is the performance of non-auditservices by the external auditors and its effect on auditor independence. Over the past decade,accounting firms have expanded heavily in the fields of information technology consulting,risk management, tax preparation and planning, and consulting and they frequently cross-sellthese services to their audit clients. Enron paid Arthur Andersen more than $50 million in2000, mostly for non-audit services and many have cited this to show that the Andersenauditors may have lacked objectivity. Given that non-audit services are lucrative and thatmanagement generally retains and directs the auditor in the performance of non-auditservices, external auditors may have an incentive not to alienate management by disagreeingwith it. Some observers fear that this creates an irresolvable conflict and there have beennumerous proposals, legislative and otherwise, to bar companies from purchasing some or allnon-audit services from their external auditor. However, even if a company decides not topurchase non-audit services from its external auditor, distinguishing these from audit servicesis often difficult. For instance, tax preparation services are closely related to the auditfunction and it may be most sensible to have the external auditor perform this service.Determining the appropriate scope of the services the external auditor should perform mayrequire careful discussions between the Audit Committee, management and the externalauditor.

In any event, Audit Committee members and other directors should recognize that this is avery sensitive issue in the current climate. For example, CalPERS has recently indicated thatit will actively oppose the election of any director who, while sitting on the company’s AuditCommittee, approved retaining an external audit firm when that firm also provided consultingor internal audit services to a company. CalPERS also has announced its intention to opposethe shareholder approval of any external auditor that also performs consulting or internalaudit services to the company. If the company does decide to retain some non-audit servicesfrom external auditors, it should consider including some additional disclosure in its proxystatement; SEC rules require disclosure of the amounts of audit services and non-auditservices, but it might be appropriate to include also a description of the nature of non-auditservices.


• EXTERNAL AUDITOR ROTATION

Some commentators are suggesting that companies should rotate their auditors periodically.CalPERS has announced that it will publicly oppose shareholder approval of any auditor thathas been retained by a company for more than five years. However, there is currently no legalrequirement that companies mandate a fixed tenure rotation of their auditors and we believethat most companies currently do not plan to do so. Indeed, there may well be other stepsthat are more effective to ensure auditor independence. Nonetheless, it may be worthwhileto consider the company’s policy in conjunction with the Audit Committee’s periodic reviewof auditor performance. In doing so, the Audit Committee should consider the expense anddisruption associated with a switch as the new auditor familiarizes itself with the company’sbusiness and controls.

• COMMUNICATIONS WITH EXTERNAL AUDITORS

SEC rules, together with accounting rules, require that external auditors communicate anumber of issues to Audit Committees, including judgments about the quality of thecompany’s accounting policies, internal audit function, disagreements with management anddifficulties encountered in performing the audit. Moreover, the Audit Committee should planto meet with the external auditor independent of management.

In addition, members of the Audit Committee should ask questions of the external auditoruntil they are confident that they understand what the financials say and the approach used inpreparing them. Warren Buffett, CEO of Berkshire Hathaway and a member of numerousAudit Committees, suggests four simple questions to determine if a company is pushing theenvelope with its accounting: (1) Would the auditor have done anything differently if healone were responsible for the financial statements?; (2) If the auditor were an investor,would he have the essential information needed to properly understand the company’sfinancial performance?; (3) Is the company using the same internal audit procedure that theauditor would follow if he were CEO (and, if not, what are the differences and why)?; and(4) Lastly, does the auditor know of anything that would cause a significant change in movingrevenue or profit from quarter to quarter that would indicate an attempt to manage earnings?Asking these and other questions can help the Audit Committee to assess the quality andintegrity of the company’s financial statements.

• INTERNAL AUDIT STAFF REVIEW

In addition, if the company has an internal audit department, the Audit Committee shouldhave access to the department and meet independently with it. The Audit Committee shouldperiodically review the quality of the senior internal auditing executive, and it may beappropriate to consider ongoing concerns like the competence, and the adequacy of thebudget and staffing of, the internal audit department. In any event, it should be clear, as it isfor external auditors, that this internal audit chief’s ultimate accountability is to the AuditCommittee and to the Board of Directors.

Some commentators have suggested that companies should exercise caution in hiring internalaudit personnel who currently provide or previously provided services to the companythrough the external auditor because of the potential that external auditors will be reluctant to


raise issues with company management if there is a possibility that they will be invited in-house.Frequently, these parties suggest that the company wait at least three years after the auditorceases to perform services for the company before offering the auditor a position. Theseconcerns should be considered, but Audit Committees should also consider whether such arestriction would interfere with hiring the best person for the job; a ban on hiring former auditorpersonnel may be too mechanical. However, if a significant portion of the staff consists ofexternal auditor alumni, the Audit Committee should consider whether this affects theindependent judgment of the internal or external auditors.

• REVIEW OF INTERNAL CONTROLS

The Audit Committee should understand and periodically assess the company’s system ofcontrols. To this end, the Audit Committee should discuss controls with the external and internalauditors and review any management letters prepared by the auditors. Where the external orinternal auditors have recommended changes to the system of controls, the Audit Committeeshould give the changes careful consideration and discuss with management anyrecommendations that management has declined to follow. This is particularly true ifweaknesses identified in a previous year’s report reappear as weaknesses in the current year’sreport.

PRACTICAL CONSIDERATIONS

COMPOSITION OF THE AUDIT COMMITTEE

In 1999, the New York Stock Exchange and the Nasdaq Stock Market responded to concerns aboutearnings management and the report of the Blue Ribbon Committee on Improving theEffectiveness of Corporate Audit Committees by instituting required qualifications for AuditCommittee members. Each exchange now requires Audit Committee members to possess aspecified level of financial sophistication and to be free from certain specified conflicts of interest.However, it is essential that those who appoint Audit Committee members recognize that thesequalifications are a minimum standard and should not represent the end of their inquiry.

When boards consider the selection of Audit Committee members, they should also consider eachcandidate’s willingness to devote time to the process, intellectual curiosity and ability to askprobing questions. Also, the Board should consider relationships (whether or not they currentlyrequire disclosure) that could cause investors or regulators to question a director’s independence,particularly in hindsight. For example, after Enron’s collapse, revelations that Audit Committeemembers had personal or financial connections to Enron’s management suggested that the AuditCommittee members were not truly independent. Audit Committee members should be free notonly from those conflicts that exchange regulations specify, but also those that might give rise tothe appearance of a conflict. An Audit Committee is only as good as its personnel and the Boardof Directors should consider all factors that might affect Audit Committee member performance.


CHARTER REVISIONS

In light of the above concerns, many companies are inclined to revise their Audit Committeecharters, both to update Audit Committee processes and to provide Audit Committee memberswith clearer guidance about their responsibilities. The Audit Committee in fact is required toreview the charter’s adequacy annually.

While the temptation may be to radically revise the Audit Committee charter by adding acomprehensive list of the tasks that an Audit Committee might undertake, there are severalreasons why directors should exercise caution in doing so. First, there is a substantial likelihoodthat new rules will be promulgated by Congress, the SEC and the stock exchanges in the nearterm, which might require further revisions. Second, an exhaustive list of Audit Committeeresponsibilities might cause Audit Committee members to take a "check the box" approach andengage in cursory review of each item (particularly if they are many in number). Third, anAudit Committee charter should not assign more tasks than an Audit Committee member canreasonably be expected to perform. Fourth, a document that purports to be exhaustive mightblind Audit Committee members by focusing their attention on discrete issues rather thanengagement in the process. Fifth, the more specific the enumerated tasks, the less flexibility theAudit Committee has to approach the fulfillment of its responsibilities and the greaterlikelihood that one of the specific items may be omitted, creating potential liability. Finally, thecompany or the business conditions affecting the company may themselves change, and AuditCommittee members should not be locked into an inflexible process. As expressed below, ourrecommendation is that the charter be crafted more as an expression of principles to beobserved. We have attached Pillsbury Winthrop LLP’s model Audit Committee Charter asExhibit A. Where the Audit Committee needs more detailed guidance regarding its periodicobligations, it may be advisable to have counsel to the Audit Committee prepare a calendar oftasks.

In some cases, the Board might want to consider reducing the breadth of the Audit Committee’sresponsibility. Where the Audit Committee is responsible for non-audit functions (e.g.,overseeing legal and regulatory compliance or ethics systems and controls), the Board maywish to reassign tasks to another committee or create a new committee to handle theresponsibility. In the near term (and possibly longer), it will likely require more time for theAudit Committee to fulfill its existing obligations. In most cases, Audit Committee memberscan obtain all of the information they need to make informed judgments if other committees,together with the general counsel, risk management officers and other appropriate members ofmanagement report to the Audit Committee periodically on significant issues they encounterthat could materially affect the financial condition or results of operations of the company.

It is important that the Audit Committee charter enable Audit Committee members to obtainindependent, professional advice, whether from accountants, attorneys or other relevantexperts, for two reasons. First, while it is not necessary in most circumstances, for difficultissues, independent, professional advice can provide Audit Committee members with ameaningful opportunity to ensure the integrity of their review. Second, in the event that theiractions are later challenged, the fact that they had the ability to solicit and, if they felt itwarranted, actually sought such advice is important to show the legitimacy and thoroughness oftheir review and their ability to bring an unbiased, informed eye to their responsibilities.


Any revisions that the Board of Directors chooses to make to an Audit Committee chartershould reflect the following concerns: (1) they should avoid boilerplate fixes and address theactual needs and practices of the company; (2) they should ensure access to resources and toinformation both within the company and independent of it; (3) they should allow theCommittee flexibility in how to perform its job and adapt to changing circumstances; and (4)they should encourage members to actively engage in the thoughtful review and questioningthat are the purpose of the Audit Committee.

SCHEDULING OF AUDIT COMMITTEE MEETINGS

The proper scope of the Audit Committee’s inquiry varies from company to company dependingon the size and complexity of a company’s business. While in the past, many Audit Committeeshave confined their activities to quarterly meetings, this may be insufficient in the current climate,depending on the circumstances. The Audit Committee should meet as often as necessary. Atsome companies, Audit Committees are meeting as often as eight to ten times per year.

Audit Committees should consider not just the frequency of meetings, but also the timing ofperiodic meetings. In light of the acknowledged greater role (some would say merely greaterrecognition) of the Audit Committee in the preparation of MD&A, it should be involved in a timelyreview of the company’s quarterly reports. At some companies, a member of the Audit Committeeattends the drafting of the earnings release and reports to the other members by telephone on theprocess. We recommend that the Audit Committee (or some subset thereof) meet to discuss thecorporation’s preliminary draft financial statements prior to the release of earnings and the actualearnings release before it is issued. If the meeting is not conducted until after the earnings releaseand the Audit Committee discovers questionable items, it may be too late for the Audit Committeeto offer input to address these—by then, the corporation may be in the unenviable position ofhaving to issue a corrective disclosure. Audit Committees should also take into account that theSEC has formally proposed expediting the periodic reporting process to require companies to fileannual reports within 60 (rather than 90) days and quarterly reports within 30 (rather than 45) days.

In addition to periodic meetings, there may be other situations in which the Audit Committeeshould gather. For instance, prior to the consummation of any large or unusual transactions,such as an acquisition or a significant financing, it may be appropriate for the Audit Committeeto meet to review the terms of the transactions with the internal and external auditors,particularly if the accounting characterization of the transaction could have a significant effecton whether the Board of Directors would want to proceed with the transaction. In the near term,it is advisable for the Audit Committee to convene a special meeting to discuss ongoingconcerns (i.e., those not related to a specific reporting cycle) such as the adequacy of the AuditCommittee’s procedures and the external and internal auditor review process, and some AuditCommittees may wish to hold regular self-assessment meetings.

In addition, many Audit Committees are reevaluating the length of their meetings. Meetingsmust allow time for discussion and probing questioning of the company’s management andexternal and internal auditors, including executive sessions with the external and internalauditors. Robert Herdman, Chief Accountant of the SEC, recently stated that, in his view, hour-long meetings are simply insufficient to provide for adequate review. Many companies areholding committee meetings the afternoon before the day of meetings of the full Board.


STRUCTURAL REFORMS

In light of the new focus on the responsibilities of the Audit Committee, some companies areconsidering increased compensation for directors serving on the Audit Committee. If the Boarddetermines that additional compensation is in order, the increase should probably be based inpart on the number of meetings a director attends, as well as the expected duration of suchmeetings.

Others have suggested that the Audit Committee’s tasks might be more manageable ifcorporations either dedicated staff to the Audit Committee or appointed a director as a full-timeAudit Committee chair. We are skeptical of these suggestions because such measures mightcause the Audit Committee to become entrenched and lose the objectivity that its membersshould bring to the review process as outsiders.

One reform that everyone supports is continuing education. To improve Audit Committeeperformance, members should have access to continuing education about auditing issues, inparticular those that affect the company and the company’s industry generally. Manycompanies provide periodic seminars or retreats for the Board as a whole on the criticaloperations of the company, and several organizations, including the National Association ofCorporate Directors as well as the larger accounting firms, provide programs geared toeducating Audit Committee members about the performance of their duties. Such programsalso may help to establish the bona fide nature of directors’ financial literacy and the fact thatthey are taking seriously their duty of care obligation. Again, where an Audit Committeemember is having difficulty understanding a transaction and neither the auditors normanagement is capable of explaining it in a satisfactory manner, the Audit Committee membershould be able to seek expert advice from an outside advisor.

AUDIT COMMITTEE STANDARDS OF CONDUCTMany Audit Committee members want to know if they face increased exposure based on theirperformance of Audit Committee obligations in the wake of Enron. In general, the answer isthat while the black letter legal standards have not changed, Audit Committees will almostcertainly face greater regulatory, judicial and especially public scrutiny. At the same time, theincreased focus on the responsibilities of Audit Committee members may mean that AuditCommittee members have to work harder and underscores the need for them to be fully engagedin the process in order to establish that they have satisfied their legal duty of care. The SECalready is pressing for greater involvement of the Audit Committee in the financial disclosureprocess, including the preparation of some portions of the MD&A.

STATE LAW STANDARDS

Like other directors, Audit Committee members have two primary duties: the duty of loyaltyand the duty of care. The duty of loyalty requires a director to discharge responsibilities as amember of the board in good faith and in a manner that the director reasonably believes to bein the best interests of the corporation.


For Audit Committee members, the duty of care is likely to be the more relevant area of inquiry.The duty of care requires directors, prior to the making of any business decision, to informthemselves of all material information reasonably available to them. (In non-Delawarejurisdictions, this requirement is usually expressed as that level of care that a person in likeposition would reasonably believe appropriate under similar circumstances.) For AuditCommittee members, this includes the need to pay attention, to prepare for meetings and toactively engage—with constructive skepticism—in discussions with management and the externaland internal auditors. Related to the duty of care is a duty to "monitor"–the duty to attempt toensure that an adequate corporate information and reporting system exists. In fulfilling theseobligations, the Audit Committee is entitled to reasonably rely on the records of the corporation,information presented to the corporation by any of the corporation’s officers or employees orcommittees, the external auditor, legal counsel and other advisors, as long as members of the AuditCommittee are confident as to the qualifications or integrity of these parties.

In addition to the above, Audit Committee members also assume responsibility for performing thespecific tasks delegated to the Audit Committee by the Audit Committee charter.

Courts, particularly Delaware courts, generally apply a liberal standard in reviewing the performanceof these duties. Absent unusual circumstances (such as a transaction involving a conflict of interest),the courts in duty of care cases apply the "Business Judgment Rule," which is a presumption that inmaking a business decision, the directors of a corporation acted on an informed basis, in good faith andwith the honest belief that the action taken was in the best interest of the corporation. The philosophybehind this rule is that directors generally know what they’re doing and that courts should not second-guess good faith business decisions so long as the Board or committee is following reasonableprocedures. This standard is well-established and has not been changed by recent events. Nonetheless,how this standard is applied may change in the post-Enron era because courts are sometimes swayedby significant events in much the same way as agencies, investors and other constituencies. Manypeople view Enron’s collapse as a wake-up call for directors, and as a result, courts may display greaterskepticism when considering whether directors have satisfied their duty of care.

In addition, in the financial areas they are assigned, Audit Committee members may find that theyhave more work to do in satisfying these duties than other directors, for several reasons. First,because of the role assigned by the Audit Committee charter, the Audit Committee member isresponsible for more tasks than the other directors. This means that in considering whether theAudit Committee member made an informed decision, or appropriately fulfilled its duty tomonitor, a court might look at a charter that says the Audit Committee member is responsible forconsidering a number of different items and ask whether the Audit Committee member failed toconsider any of them. Second, Audit Committee members may have greater qualifications thanother directors, including both those mandated by stock exchange rules (freedom from conflicts ofinterest and financial sophistication) and presumably those personal characteristics that would leadthe Board of Directors to appoint him or her as an Audit Committee member, such asindependence and inquisitiveness. A court may take the qualifications of each Audit Committeemember into account in considering whether the director’s actions or oversight were appropriate.

Overall, it is likely that courts will recognize the job of an Audit Committee member is a difficult oneand employ liability standards in an appropriate manner. It would not serve anyone’s interest if themost capable candidates were discouraged from serving on Audit Committees due to a heightenedthreat of liability. Nonetheless, Audit Committee members should be cognizant that theirresponsibilities in the financial reporting area (and any other areas assigned to them by the charter) aregreater than those of other directors, and that courts may be less liberal in the post-Enron era.


SECURITIES-RELATED STANDARDS

For several years, the SEC has required corporations to include in their proxy materials a reportby the Audit Committee stating whether the Audit Committee has reviewed the financialstatements and conducted a number of specified discussions with management and the externalauditors and a statement that, based on the foregoing, the Audit Committee recommends to thecompany’s Board of Directors that the audited financial statements be included in thecompany’s annual report on Form 10-K. In addition, as indicated above, the SEC is currentlyconsidering mandatory disclosure about the degree of involvement of the Audit Committee inreviewing specific portions of a company’s MD&A.

Under Rule 10b-5 of the Securities Exchange Act of 1934, a director can be held liable for apublic statement that is false or misleading as to a material fact if the statement is made withrecklessness (in the Ninth Circuit, a "conscious" recklessness) or knowledge of its falsity, thestatement is made in connection with the purchase or sale of securities and the plaintiff canshow that relying on the statement caused him or her a loss. In the context of the sale of thecompany’s securities, however, a more stringent liability standard may apply. For instance, ifa registration statement were involved, directors of the issuer could be liable for, e.g., theMD&A disclosure unless, after reasonable investigation, they reasonably believed that itcontained no material misrepresentations or omissions (the so-called "due diligence" defense).And, while to our knowledge the SEC has never brought an action against an Audit Committeemember as such, the SEC’s Director of Enforcement recently indicated that in any financialreporting matter that the SEC investigates, it will look at the Audit Committee’s conduct.

Cases frequently arise where a private plaintiff alleges that a financial statement contains a falsestatement that has caused a loss and that the officers and directors have participated in themaking of the false statement. Courts generally hold that the outside directors of thecorporation are insufficiently involved in the affairs of the corporation and the preparation offinancial statements to be liable. However, various courts have drawn a distinction betweenAudit Committee members and other outside directors. In certain cases, this has made it moredifficult in litigation for Audit Committee members, who have greater access to information andare involved in review of the preparation of financial statements; they are less likely to be ableto cause claims against them to be dismissed on summary judgment where they involvefinancial matters.

RECOMMENDATIONS FOR AUDIT COMMITTEE MEMBERS

In the near term, there are a number of action items that Audit Committee members shouldconsider in light of the foregoing:

• The Audit Committee charter should be reviewed generally to ensure that it is state-of-the-art and should be reevaluated at least annually.

• The Audit Committee should endeavor to ensure that all of its activities are adequatelydocumented, just as those of the full Board would be.

• The Audit Committee should not lose sight of the fact that its role is to assist the Board ofDirectors in fulfilling the Board’s oversight responsibility and it should not hesitate toinvolve the Board of Directors at critical junctures.


• Audit Committee members might wish to review their current directors liability insurancecoverage.

• Delaware and, to differing extents, other states permit shareholders to adopt a provision in thecertificate of incorporation to exculpate directors from any personal liability for the payment ofmonetary damages for breaches of their duty of care. A review of the company’s charterdocuments should be conducted to assure that they are state-of-the-art in this regard.

• Most state laws permit corporations to provide for the indemnification of directors againstexpenses stemming from civil, criminal, administrative or investigative proceedings providedthat the director acted in good faith and in a manner the director reasonably believed to be in thebest interests of a corporation. These indemnification provisions should be reviewed to ensurethat they take full advantage of state statutes. In addition, most state laws permit directorindemnification contracts, which can provide greater coverage than the state indemnificationstatutes. If Audit Committee members do not have such protection already, they may wish tosuggest that the rest of the Board of Directors consider taking steps to arrange it.

• As stated above, Audit Committee members should also ensure that their Audit Committeecharter provides for proper access to independent, professional advice.

• Finally, and most importantly, members of the Audit Committee should approach their inquirieswith constructive skepticism and make sure that the process they establish to perform theirdelegated oversight responsibility is both reasonable for the company in question and observedin practice.

Although these considerations are important, the most important thing that any Audit Committeemember can do to limit exposure is to bring an informed, alert and inquisitive approach to AuditCommittee duties. Audit Committee members should be sure to understand what theirresponsibilities are and that they have the resources to perform them—the time, acumen, access toinformation and support to do the job effectively. At the end of the process, the Audit Committeemember should feel comfortable enough with the financial statements and the process that producedthem to be confident that investors can rely on the integrity of a company’s reports.

London • Los Angeles • New York • Northern Virginia • Orange County • Sacramento • San Diego • San Francisco • Silicon Valley • Singapore • Stamford • Sydney • Tokyo • Washington DC

The Memorandum is only a general review of the subjects covered and does not constitute an opinion or legal advice. © 2002 Pillsbury Winthrop LLP. All Rights Reserved.

Michael J. Halloran415.983.1610

[email protected]

Arthur H. Fredston212.858.1210

[email protected]

Nathaniel M. Cartmell III415.983.1570

[email protected]

Stephen R. Rusmisel212.858.1442

[email protected]

www.pillsburywinthrop.com

Jonathan D. Joseph415.983.1071

[email protected]

Mark R. Hellerer212.858.1787

[email protected]


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EXHIBIT A

PILLSBURY WINTHROP LLP

MODEL CHARTER OF THE AUDIT COMMITTEE

OF THE BOARD OF DIRECTORS OF

[COMPANY NAME]1

PURPOSE AND COMPOSITION

This Charter governs the operations of the Audit Committee. The Audit Committee shall be comprised of three or moredirectors as determined by the Board of Directors and shall meet the qualification requirements of the applicable stock marketrules.2

1 Both the NYSE and the Nasdaq Stock Market have listing standards that require that listed companies have a formal written charter. See the NYSE Manualat ß 303.01(B)(1) and Rule 4350(d)(1) of the Nasdaq Stock Market Rules. The charter is adopted by the full Board of Directors. The provisions containedin this model Audit Committee Charter may not be suitable to every company. Please consult with a Pillsbury Winthrop LLP attorney to ensure that theAudit Committee Charter your Board of Directors adopts is appropriate to your company.

2 The NYSE requires that (1) each Audit Committee member (a) have no relationship to the Corporation that may interfere with the exercise of his or herindependence from the management and from the Corporation; (b) be financially literate, as such qualification is interpreted by the Board of Directors inits business judgment, or become financially literate within a reasonable time after his or her appointment to the Audit Committee; and (2) at least onemember have accounting or related financial expertise, as such qualification is interpreted by the Board of Directors in its business judgment. However, theNYSE Manual also provides that under exceptional and limited circumstances, one director who is no longer an employee or who is an immediate familymember of a former executive officer of the company or its affiliates but who does not otherwise meet the qualifications for independence may be appointedto the Audit Committee if the Board of Directors determines in its business judgment that membership of that individual on the Audit Committee is requiredby the best interests of the corporation and its shareholders.

The Nasdaq Stock Market rules require that (1) no officer or an employee of the Corporation or its subsidiaries or any other individual having a relationshipwhich, in the opinion of the Board of Directors, would interfere with the exercise of independent judgment shall be a member of the Audit Committee; (2)each member be able to read and understand fundamental financial statements, including a company’s balance sheet, income statement and cash flowstatement or become able to do so within a reasonable period of time after his or her appointment to the Audit Committee; and (3) at least one member havepast employment experience in finance or accounting, requisite professional certification in accounting or any other comparable background that results inthe individual’s financial sophistication, including having been a chief officer or other senior officer with financial oversight responsibilities. However, theNasdaq Stock Market Rules also provide that under exceptional and limited circumstances, one director who is not an employee or an immediate familymember of an employee but who does not otherwise meet the qualifications for independence may be appointed to the Audit Committee if the Board ofDirectors determines that membership of that individual on the Audit Committee is required by the best interests of the corporation and its shareholders.

If the Board of Directors has any question as to the suitability of a candidate for the Audit Committee, it should refer to the relevant listing standards for amore detailed explanation of how each exchange defines the terms. The standards are contained in Section 303.01 of the NYSE Manual and Rules 4200and 4350 of the Nasdaq Stock Market Rules, respectively.


The members of the Audit Committee shall be elected by the Board of Directors annually and shall serve until theirsuccessors are duly elected and qualified. Unless a Chair is elected by the full Board of Directors, the members of the AuditCommittee may designate a Chair by majority vote of the full Audit Committee membership.

STATEMENT OF POLICY

The Audit Committee shall provide assistance to the Board of Directors in overseeing the financial reporting process,the systems of internal accounting and financial controls, the performance and independence of the external [and internal]3

auditors, and the annual independent audit of the Corporation’s financial statements.4

The external auditor for the Corporation [and the head of the internal audit staff] is [are] ultimately accountable to theAudit Committee and the Board of Directors. The Audit Committee and the Board shall have the ultimate authority andresponsibility to select, evaluate and, where appropriate, replace the external auditor [and the head of the internal audit staff].5

RESPONSIBILITY AND PROCESSES

The primary responsibility of the Audit Committee is to oversee the Corporation’s financial reporting process on behalfof the Board of Directors and report the results of their activities to the Board of Directors. It is not the duty of the AuditCommittee to plan or conduct audits, to determine that the Corporation’s financial statements are complete and accurate and arein accordance with generally accepted accounting principles or to assure compliance with laws. These are the responsibilitiesof management [, the internal auditor] and the external auditor. In carrying out its responsibilities, the Audit Committee’spolicies and procedures should remain flexible in order to react to changing conditions and circumstances.

The following shall be the principal recurring processes of the Audit Committee in carrying out its oversightresponsibilities. The processes are set forth as a guide with the understanding that the Audit Committee may alter or supplementthem as appropriate.

1. Annually, the Audit Committee shall recommend to the Board of Directors the selection of the Corporation’s externalauditor, subject to stockholder ratification of the selection, if such ratification is required or sought.

3 Throughout this document, the term “internal auditor” is bracketed to indicate that those companies that do not have an internal audit function should omitthe reference.

4 The Caremark case holds that the Board of Directors must attempt to ensure that an adequate corporate information and reporting system exists. See Inre Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). At many companies, this responsibility is largely delegated to the AuditCommittee, which is made responsible for review of systems and controls relating to legal and ethical compliance programs, regulatory compliance andbusiness risk assessment. However, given the heightened role of Audit Committees, many companies are considering delegating some of these functionsto other committees and having these committees periodically report to the Audit Committee or the Board of Directors.

5 Both the NYSE and the Nasdaq Stock Market require that the Audit Committee charter specify that the external auditor is ultimately accountable to theAudit Committee and the Board of Directors. See the NYSE Manual at § 303.01(B)(1)(b) and Rule 4350(d)(1)(C) of the Nasdaq Stock Market Rules.


2. The Audit Committee shall discuss with [the internal auditors and] the external auditor the overall scope and plansfor its respective audit examinations.

3. The Audit Committee shall ensure that the external auditor submits annually a formal written statement delineatingall relationships between the external auditor and the Corporation. The Audit Committee is responsible for engaging in adialogue with the external auditor with respect to such disclosed relationships that may impact the objectivity and independenceof the external auditor and recommending that the Board of Directors take appropriate action to satisfy itself of the externalauditor’s independence.6

4. The Audit Committee shall establish policies and procedures for the engagement of the external auditor to providenon-audit services, and consider whether the external auditor’s performance of any non-audit services is compatible with theexternal auditor’s independence.

5. The Audit Committee shall discuss with management [, the internal auditors] and the external auditor the adequacyand effectiveness of the Corporation’s accounting and financial records and system for monitoring and managing business riskand legal compliance programs. Further, the Audit Committee shall meet separately with [the internal auditors and] the externalauditor, with and without management present, to discuss the results of their examinations.

6. The Audit Committee shall review and discuss with management [, the internal auditor] and the external auditor theCorporation’s interim financial results to be included in the Corporation’s quarterly reports filed with the Securities andExchange Commission, and the matters required to be discussed by Statement on Auditing Standards No. 61 (Communicationswith Audit Committees), as it may be modified or supplemented. 7

7. The Audit Committee shall review with management [, the internal auditor] and the external auditor the financialstatements to be included in the Corporation’s Annual Report on Form 10-K (or the annual report to shareholders if distributedprior to the filing of Form 10-K),8 as well as the auditor’s judgment about the quality, not just acceptability, of the Corporation’saccounting principles as applied in its financial reporting.9 The review shall also include a discussion of the reasonableness ofjudgments and estimates made in the preparation of the financial statements that may be viewed as critical, as well as the clarityof financial statement disclosures.10 In addition, the Audit Committee shall discuss the results of the annual audit and any othermatters required to be communicated to the Audit Committee by the external auditor under generally accepted auditingstandards, including the matters required to be discussed by Statement on Auditing Standards No. 61 (Communications withAudit Committees), as it may be modified or supplemented.11

6 This paragraph follows the listing requirements of the NYSE and the Nasdaq Stock Market. See the NYSE Manual at ß 303.01(B)(1)(c) and Rule4350(d)(1)(B) of the Nasdaq Stock Market Rules. Item 306(a)(3) of Regulation S-K also requires that the Audit Committee’s report disclose this discussion.

7 This review should occur prior to the Corporation’s filing of the Form 10-Q and, where possible, before the release of earnings reports.

8 Item 306(a)(1) of Regulation S-K requires that the Audit Committee’s report disclose this discussion.

9 The review of the quality of accounting principles is required by Statement of Accounting Standards 61, as amended by Statement of Accounting Standards 90.

10 In a December 12, 2001 release entitled “Cautionary Advice Regarding Critical Accounting Policies”, the SEC announced its intention to consider creatingnew rules to elicit more precise disclosure of accounting policies that management believes most critical. Although the SEC has not yet promulgated suchrules, it did indicate in that release that Audit Committees should review the selection, application and disclosure of such policies prior to


8. Based on its review and discussions of items 3 and 7, the Audit Committee shall recommend to the Board ofDirectors whether the financial statements should be included in the Annual Report on Form 10-K (or the annual report toshareholders if distributed prior to the filing of Form 10-K).12

9. As a whole, or through the Chair, the Audit Committee shall review the impact on the financial statements ofsignificant events, transactions, or changes in accounting principles or estimates which potentially affect the quality of thefinancial reporting with management [, the internal auditor] and the external auditor prior to the filing of the Corporation’sReports on Form 10-Q or 10-K, or as soon as practicable if the communications cannot be made prior to its filing.13

10. Management and the external auditor shall discuss with the Audit Committee significant changes to theCorporation’s auditing and accounting principles, policies, controls, procedures and practices proposed or contemplated by theexternal auditor, [the internal auditors] or management.

11. The Audit Committee shall review and reassess this Charter annually and recommend any appropriate changes tothe Board of Directors.14

The Audit Committee shall review any significant disagreement that is brought to its attention, after inquiry, amongmanagement and the external auditor [or the internal auditor] in connection with the preparation of the Corporation’s financialstatements. In addition, the Audit Committee shall review with management and the external auditor any pending or threatenedaction by regulators or government agencies and any employee complaints or published reports that raise material issuesregarding the Corporation’s financial statements or accounting policies. The Audit Committee may request any officer oremployee of the Corporation or the Corporation’s outside counsel or external auditor to attend a meeting of the Audit Committeeor to meet with any members of, or consultants to, the Audit Committee. The Audit Committee shall also have the resourcesand authority appropriate to discharge its responsibilities, including the authority to engage outside auditors for special audits,reviews and other procedures and to retain special counsel and other experts or consultants.15

finalizing and filing annual reports. See Release Nos. 33-8040; 34-45149; FR-60. Many issuers have responded with enhanced disclosures about thejudgments and estimates that they perceive to be most critical.

11Item 306(a)(2) of Regulation S-K requires that the Audit Committee’s report disclose this discussion.

12Item 306(a)(4) of Regulation S-K requires that the Audit Committee prepare a report that includes this disclosure.

13The review of the impact of significant events is required by Statement of Accounting Standards 61, as amended by Statement of Accounting Standards 90.

14Both the NYSE and the Nasdaq Stock Market require the Audit Committee to review its charter annually. See the NYSE Manual at ß 303.01(B)(1) andRule 4350(d)(1) of the Nasdaq Stock Market Rules.


REPORTS

1. The Audit Committee shall prepare or cause the preparation of the report required by the rules of the Securities andExchange Commission for inclusion in the Corporation’s annual proxy statement.16

2. The Committee shall submit any recommendations for changes to the Audit Committee Charter to the full Board ofDirectors for approval.

3. The Audit Committee shall maintain minutes of its meetings and regularly report its activities to the Board ofDirectors.

RELIANCE ON INFORMATION PROVIDED

In adopting this Audit Committee Charter, the Board of Directors acknowledges that the Audit Committee members arenot employees of the Corporation and are not providing any expert or special assurance as to the Corporation’s financialstatements or any professional certification as to the external auditor’s work or auditing standards. Each member of the AuditCommittee shall be entitled to rely on the integrity of those persons and organizations within and outside the Corporation thatprovide information to the Audit Committee and the accuracy and completeness of the financial and other information providedto the Audit Committee by such persons or organizations absent actual knowledge to the contrary.

London • Los Angeles • New York • Northern Virginia • Orange County • Sacramento • San Diego • San Francisco • Silicon Valley • Singapore • Stamford • Sydney • Tokyo • Washington DC

The Charter is only a general review of the subjects covered and does not constitute an opinion or legal advice. © 2002 Pillsbury Winthrop LLP. All Rights Reserved.

15 Please note: this item is not separately numbered because, unlike the other items in this section, significant disagreements between the external auditorand management or circumstances that require meetings with third persons or independent experts would not normally be recurring regularly.

16 Item 7(d)(3)(i) of Schedule 14(a) (“Information Required in Proxy Statement”) requires that the corporation’s annual proxy statement include the reportof the Audit Committee described in Item 306 of Regulation S-K.

Michael J. Halloran415.983.1610

[email protected]

Arthur H. Fredston212.858.1210

[email protected]

Nathaniel M. Cartmell III415.983.1570

[email protected]

Stephen R. Rusmisel212.858.1442

[email protected]

www.pillsburywinthrop.com

Jonathan D. Joseph415.983.1071

[email protected]

Mark R. Hellerer212.858.1787

[email protected]

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