The 1991 banking law vastly expands the role of the audit committee at a bank or thrift with more than $150 million in assets, while making most traditional duties mandatory.
The audit committee must "review" the new annual report that management is required to prepare -- a report covering a variety of accounting, audit, control, and compliance matters. (See American Banker, Oct. 30, page. 5).
The new rule also suggests that the audit committee review call reports "for accuracy and timeliness," review the adequacy of internal controls and management's handling of certain material inadequacies and reportable conditions, and "supervise" the internal audit function.
The duties are broad, and the audit committee has no road map or specified procedures for fulfilling its broader legal responsibilities.
Perhaps the open-endedness of the proposed rule reflects the audit committee's place in the theoretical framework of the 1991 banking law. The committee is, as mandated, quite simply everybody's watchdog.
It is required to be independent, to have financial expertise, and to have access to counsel who, under the proposed rule, would be the most rigorously independent counsel envisioned under any regulatory system.
Criteria of Independence
At banks and thrifts with over $150 million of assets, audit committee members of must be "independent persons."
This means that within the preceding three years no member can have been (1) an officer, employee, affiliate, or associate (as those terms are defined for securities law purposes) of the bank or thrift or one of its affiliates: (2) an immediate family member of one of these; or (3) a 5% stockholder.
Additional categories of business relationships, such as securities underwriters, also are excluded.
At "large" institutions, with more than $500 million in assets, audit committee members also cannot be "large customers" or "represent" large customers, and two members must have "banking or related financial expertise."
Here the Federal Deposit Insurance Corp.'s proposed rule is relatively lenient. A large customer is defined as having in excess of 15% of the institution's capital, and the requirement for banking or related financial expertise can be fulfilled by having served on the bank's board of directors for five years.
Still, many banks may have difficulty complying with the requirements for an independent committee.
Some Flexibility
The rule does not set a minimum number of audit committee members.
For banks that need to elect new board members, the proposed rule would give them until the next annual meeting after Dec. 31 of this year.
Members of the audit committee of a holding company are explicitly permitted to serve on the audit committees of subsidiaries.
Thus, if a subsidiary is required to file a report separate from that of its holding company, the subsidiary's report can be reviewed by the same audit committee that serves the parent holding company. (A separate report would be required if the subsidiary had assets of more than $9 billion or were not rated 1 or 2.)
Strict Rules on Counsel
The degree of independence that the FDIC envisions audit committees exercising is further demonstrated by the provisions regarding counsel. The statute requires that independent audit committees have access to their own counsel.
The proposed rule would establish strict independence rules for this counsel -- indeed, rules far more strict than apply to audit committee members themselves.
For example, the audit committee's counsel cannot do any other work for the bank or discuss with it the possibility of employment. Even after terminating the relationship with the committee, the former counsel may not "be employed" by the bank during the following year.
In addition, counsel cannot concurrently represent the institution's board of directors. This last prohibition seems rather extreme if it means that counsel cannot represent outside or independent directors more generally than in their capacity as audit committee members.
Freedom in Hiring
The degree of independence expected of audit committees is also shown by the requirement that the audit committee "may retain [counsel) without prior permission of the institution's board of directors or of its management," which presumably means that the audit committee has the power to commit funds.
Nevertheless, the release states that, "at present" the FDIC is "not proposing that audit committees have counsel on retainer," though it is unlikely that a lawyer would accept the restrictions and potential liabilities that go with representation without receiving a retainer.
The proposed rule divides the audit committee's duties into two parts: one that is mandatory and one that is suggested by example.
Mandatory Duties
In practice, it appears that there is overlap between the mandatory and suggested categories. It also appears that an audit committee that fails to fulfill the optional but suggested duties will do so at its peril.
The mandatory duties basically are to review management's new annual report and the independent accountants' other reports. These reports are to be reviewed "with management and the independent public accountant."
But the proposed rule nowhere says what a review by an audit committee constitutes nor what an audit committee's responsibility is if concerns arise out of the review.
What, for example, are the audit committee's duties to require that follow-up work be done? And how should management's report (and the independent accountant's report thereon) be amended to reflect the outcome of the audit committee process?
Does the audit committee, whose members are specifically required to be listed in the report, have a right or obligation to make a separate statement?
Awkward Situations
In the early years under the rule, many situations will arise in which the rule's neat sequence of management report, independent accountant tests, independent accountant report, and audit committee review will lead to awkward situations.
In those situations it will be of paramount importance for the audit committee and its counsel, management and its counsel, and the independent accountants to work together, within the framework of their separate and independent roles.
Because delicate issues will crop up, every effort should be made to establish working relationships among the parties that will be involved. Such relationships are more difficult to create under the pressure of problems that arise in preparing a report that must be filed within 90 days after the end of the fiscal year.
One should also recognize that audit committee counsel is the participant most likely to prove difficult to work with.
This is not only because layers are naturally confrontational but also because of how Congress and the FDIC have defined the role of counsel to the audit committee.
Here is a position that will pay a modest amount per year (in relation, for example, to deal fees), and that will shut the lawyer and his/her firm out of work for the institution not only during the representation but for a year thereafter.
Also, the lawyer takes on not only the usual professional responsibilities and potential liabilities of any representation but also statutory responsibilities and the possibility of civil money penalties as an institution-affiliated party. It would be no wonder if counsel is difficult to get along with.
Don't Wait for a Crisis
My recommendation is to establish this relationship early so that at least when an awkward situation arises the people involved will have seen each other in action and will have had an opportunity to learn to trust each other.
Nor would I limit this recommendation to large banks. Banks under $500 million are at least as likely as larger ones to have awkward situations arise where the audit committee will need to have its own counsel. They, too, will be better off if the relationship predates the problem.
In dealing with each of its duties, the audit committee's performance will only be as good as its minutes. The minutes are the record on which the audit committee will be judged by examiners and on which audit committee members must defend their actions if they are sued.
Someone, therefore, must be charged with recording the audit committee's process, as well as its findings, in those minutes. They should also be reviewed by the audit committee's counsel.
The process of audit committee preparation should begin in 1992. Each audit committee should have a new charter, its own counsel, and a clear understanding of its duties and processes before 1993 begins so that nobody has any surprises.
