Historically, it has been considered a prestigious honor to be asked to serve on the board of directors of a public company. The lawyer's classic advice is that if you work hard and do your job properly, litigation is a very remote possibility, especially since you may be protected by the business judgment rule, the new stringent pleading requirements for securities fraud and that you must be a participant rather than an aider and abettor.

The Sarbanes-Oxley Act may change that advice. This new legislation greatly enhances the authority and clarifies and expands the duties and responsibilities of the audit committee. For instance, at least one member of the audit committee must have the requisite financial expertise as defined by the stock exchange on which the company securities are traded.

Although it predates Sarbanes-Oxley, In re Lernout & Hauspie Securities Litigation, 2 86 B.R.33 (D. Mass 2002) illustrates the potential liability for serving on an audit committee. In this case, the complaint alleged that each of the three members of the audit committee signed SEC filings that incorporated fraudulent financial statements. The complaint alleged that the members of the audit committee were aware of internal control problems and deficiencies, but were not in a position to deter management from disseminating false and misleading financial statements to the investing public. This would appear to be a common situation. The District Court held that the following allegations in the complaint were sufficient to raise an issue as to whether the members of the audit committee were reckless. Of course, proving recklessness and whether an independent director was a participant in the wrongful conduct is another matter.

The specific allegations were: 

1. The company had failed to implement a system of internal audit controls, as the outside auditors had been recommending for a number years; 
2. The company failed to hire an internal auditor until June 2000, despite the audit committee's commitment in August 1999 to furnish the directors with a recommendation; 
3. Although the audit committee promised the Board of Directors that would meet prior to each quarterly financial report for purposes of reviewing it, the committee continued to sign off on the financial statements in 2000, despite the continuing lack of internal controls and various red flags; 
4. The SEC was investigating the company's accounting practices since January 2000; 
5. Press releases containing financial information were not being reviewed by members of the audit committee; 
6. KPMG reports to the audit committee continually noted issues concerning cash collection and revenue recognition issues concerning operations in Korea; 
7. In a KPMG confidential letter to the chairman of the audit committee in November 1999, it stated that its limited review of the third quarter financial statements indicated that there was a problem with respect to cash collections and revenue recognition of sales in Korea; 
8. In another KPMG letter on the same day, which was also communicated to the chairperson of the audit committee, KPMG advised the company that it could not sign the audit opinion for the December 31, 1999 audit unless issues relating to outstanding receivables, revenues and Korean contracts were resolved.

In support of its motion to dismiss the complaint, the audit committee members took the position that each reasonably relied on the outside auditor. The court held that, at least for purposes of the pleading stage, such reliance may not be justified in view of KPMG's communications to the members of the audit committee about its concerns. In addition, the complaint alleged control person liability against the members of the audit committee. According to this court, although service as a member of the audit committee in and of itself does not make someone a control person, if that person signs the company's financial documents, that person may be deemed a control person.

Whether the plaintiffs can prove that any of the audit committee defendants are in a position to approve a corporation's financial statements, or be presumed to have "the power to direct or cause the direction of the management and policies of the Corporation," at least insofar as the "management and policies" referred to relate to ensuring a measure of accuracy in the contents of company financial reports and SEC registrations that they actually sign, is another matter. Also, the opinion does not discuss what the members of the audit committee should have done to prevent the issuance of alleged fraudulent financial statements.

Sarbanes-Oxley codifies certain requirements that the audit committee must be involved in, including:

• receipt of internal control reports from both management and the outside auditors,
• management reports setting forth all significant deficiencies in the design or operation of internal controls, 
• any documents relating to any fraud, whether or not material, that involves management,  
• attorney reports under section 307 alerting them of any evidence of material legal violations as to which the chief legal officer did not respond adequately, 
• developing procedures for the submissions by whistle-blowers concerning questionable accounting and auditing matters.

But at what point does receipt of this information and failure to act on such information become reckless, which is actionable under the federal securities laws rather than negligence, which is not actionable?

At the very minimum, before a person decides whether to accept appointment as an independent director and member of the audit committee, two conditions must be satisfied. First, require that the audit committee have an independent counsel who is totally unrelated to the company or its existing counsel. Second, ensure that the company has appropriate Directors & Officers ("D&O") liability insurance. Insurance companies are now in the process of developing separate policies for the protection of directors, and hopefully there will be a subcategory of policies applicable to members of the audit committee who are independent directors.

Although proof of securities fraud against an independent director who is a member of the audit committee will continue to be very difficult, surviving a motion to dismiss, especially after Sarbanes-Oxley, will be much easier for plaintiff's class-action attorneys.

• The Liability of Financial Professionals
• Audit Committee and Management Disclosure Requirements of the Sarbanes-Oxley Act
• Sarbanes-Oxley and the "Reliance on Others Defense"
• Defining "Non-Audit" Services: The Audit Committee's Role

CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Mr. Hecht would appreciate any input on subject matters within the SEC accounting area which you believe would be appropriate for a future article.