September 16, 2013
In June 2013, the New York Stock Exchange (NYSE) filed with the Securities and Exchange Commission (SEC) a proposed rule change to amend its listing requirements to provide a oneyear transition period for newly public companies to comply with the Exchange’s internal audit function requirement. For purposes of this rule, a newly public company may be a company entering into an initial public offering or created by means of a carve-out or spin-off transaction. On August 22, 2013, the SEC announced the proposed rule had been approved and that the NYSE had proposed clarifications of the audit committee’s responsibilities during the transition period.
The Approved NYSE Rule
Under the current NYSE listing standards, a listed company must have an internal audit function to provide management and the audit committee with ongoing assessments of the listed company's risk management processes and system of internal control. A listed company may choose to outsource this function to a third-party service provider other than its independent auditor. This requirement was expected to be met upon listing on the Exchange
The amendment to the aforementioned rule was made because the current listing standards also stipulate that any company transferring from another securities exchange that does not have an internal audit function requirement has one year from the date of listing to comply with the NYSE’s requirement to have an internal audit function in place. For example, the National Association of Securities Dealers (NASDAQ) rules do not require listed companies to have an internal audit function. It did not seem fair to provide a transition period in circumstances involving a transfer from another exchange while requiring newly public companies to be compliant immediately after becoming a public company and listing on the Exchange. As a result of this amendment, all newly listed companies will have a transition period, requiring them to have an internal audit function no later than one year after their initial listing date.
The rule change is provided on the SEC website at www.sec.gov/rules/sro/nyse/2013/34- 70246.pdf.
Proposed Clarifications of Audit Committee Responsibilities In addition to the one-year transition period, the SEC’s release describes the NYSE’s proposed provisions to clarify the duties of the audit committee with respect to the internal audit function during the transition period applicable to newly public companies. These clarifications address the following current listing requirements regarding provisions that must be included in the audit committee charter:
- The committee will assist board oversight of: (1) the integrity of the listed company's financial statements, (2) the listed company's compliance with legal and regulatory requirements, (3) the independent auditor's qualifications and independence, and (4) the performance of the listed company's internal audit function and independent auditors.
- The committee will meet separately, periodically, with management, internal auditors (or other personnel responsible for the internal audit function) and independent auditors.
- The committee will review with the independent auditor any audit problems or difficulties and management's response. This review is required to include, among other things, a discussion of the responsibilities, budget and staffing of the listed company's internal audit function.
- The committee will report regularly to the board of directors to review, among other things, the performance of the company’s internal audit function.
Obviously, the above requirements cannot apply to a newly public company electing to apply the one-year transition period related to the implementation of an internal audit department. As a result, some clarifications are needed. Accordingly, the NYSE has proposed to amend the above provisions to clarify the duties of the audit committee during the transition period. Specifically, during the transition period in which an internal audit function does not exist, the company’s charter must provide the following:
- The committee will assist board oversight of the design and implementation of the internal audit function.
- The committee must meet periodically with the company personnel primarily responsible for the design and implementation of the internal audit function.
- The committee’s review with the independent auditor must include a discussion of management’s plans with respect to the responsibilities, budget and staffing of the internal audit function and the company’s plans for the implementation of that function.
- The committee must review with the board the activities of management with respect to the design and implementation of the internal audit function.
The message is that the one-year transition rule should not be viewed as a “reprieve” as much as an opportunity for executive management and the audit committee to develop an internal audit function and charter in a thoughtful manner. In effect, during any transition period the audit committee will be overseeing the design and implementation of the company’s internal audit function as well as continue to have a role in overseeing the listed company’s financial systems and internal control over financial reporting.
Impact on NASDAQ Rule Making
Earlier this year, the NASDAQ proposed a new rule to require listed companies to have an internal audit function.1 In light of the breadth and nature of the comments from its issuer community and other stakeholders, the NASDAQ decided to withdraw its proposal so that it may adequately consider these comments.2 It will be interesting to observe how the NASDAQ reacts to these recent NYSE developments in light of its proposed rule that was withdrawn. It is possible they might regard the NYSE approach as a model to replicate in some way to provide a phase-in process. In withdrawing the proposed rule, the NASDAQ noted that it remains committed to the highest standards of corporate governance and believes it is important that listed companies have appropriate mechanisms and processes in place to review risks and the system of internal controls. Therefore, it stated its intent to revise the proposed rule, taking into account the comments received, and resubmit it.
It will be interesting to observe how the NASDAQ reacts to these recent NYSE developments in light of its proposed rule that was withdrawn. It is possible they might regard the NYSE approach as a model to replicate in some way to provide a phase-in process.
The board of directors is responsible for providing risk oversight and an internal audit function informs the board risk oversight process. Management needs an objective and competent internal audit function to ensure that risk management capabilities and internal control systems are functioning effectively and improved continuously over time. The NYSE’s modifications to its listing standards continues its historically strong emphasis on the importance of having an internal audit function in place, providing an example for other exchanges to consider.
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