The recently enacted German Transparency and Disclosure Act has
amended section 161 of the German Stock Corporation Act to provide,
among other things, that German publicly listed companies must
either comply with the German Corporate Governance Code (Deutscher
Corporate Governance Kodex), as promulgated by the German Federal
Ministry of Justice in November 2002, or explain why they will not
be complying with the recommendations of the Code. As stated in its
preamble, the purpose of the Code is both to restate existing
statutory rules on the management and supervision of German
publicly listed companies and to codify international and German
best practices. It is intended to provide transparency and
accountability to the German corporate governance system and foster
the confidence of foreign and domestic investors as well as
customers, employees and the general public in the management and
supervision of German publicly listed companies.
Audit committees
One recommendation of the Code is that the supervisory board of
a publicly listed company in Germany establish an audit committee
(section 5.3.2 of the Code). It is interesting to note that,
according to a survey of European companies conducted by KPMG
before the Code's promulgation (Corporate Governance in Europe,
KPMG Survey, 2001/2002), only 41% of the German respondents had
established audit committees at that time. By comparison, almost
all UK respondents reported the existence of such a committee.
The Code provides that the audit committee is responsible for
overseeing matters relating to the following:
- financial reporting;
- risk management;
- the independence of external auditors;
- the retention of external auditors;
- focal points of the audit; and
- the external auditor's fee arrangement.
Financial reporting requirements
Matters of financial reporting are addressed in section 7.1 of
the Code. This provision restates the general premises that the
consolidated financial statements of a company should provide the
main source of information for shareholders and other third parties
and that these constituencies should be kept informed through
interim reports. The Code does not say how often these reports
should be issued. That will depend on the rules of the stock
exchange and the segment in which the particular company is listed.
Based on the new rules of the Frankfurt Stock Exchange, for
instance, companies listed in the Prime Standard segment are
subject to quarterly reporting requirements while those listed in
the General Standard segment are only required to report
semi-annually.
The Code makes a distinction between the accounting principles
that should apply to consolidated financial statements and interim
reports, on the one hand, and those that apply for tax purposes or
for purposes of determining dividends and creditor protection, on
the other. In the former case, financial reports are to be
presented on the basis of internationally-accepted accounting
principles, which also include US Gaap, while in the latter case,
the annual statements should comply with the accounting standards
and principles developed under the German Commercial Code
(HGB).
While under the statutory rules of the German Stock Corporation
Act a stock corporation can have up to five months to publish its
annual report, the Code accelerates the deadlines for financial
reports. It recommends that the annual consolidated statements of a
publicly listed company be published within 90 days of the end of
the company's fiscal year and that interim reports be published
within 45 days of the end of the relevant fiscal period. The Code's
90-day rule for annual reports is even shorter than the
requirements under the Frankfurt Stock Exchange Rules for Prime
Standard companies, which allow four months for annual reports.
Risk management
Section 4.1.4 of the Code requires that the management board
ensure that appropriate risk management and risk controls are put
in place. This is a restatement of the statutory requirement in
section 91 subsection 2 of the German Stock Corporations Act, which
means that there is no availability to opt out of this requirement
by publicly explaining a company's non-compliance. Each German
stock corporation must have the appropriate risk management and
risk controls in place. In addition, section 317 subsection 4 of
the German Commercial Code requires the external auditors to review
the measures taken by the company in this respect in the context of
their annual audit of the company.
Thus, the only comply or explain flexibility provided under the
Code is whether or not the company maintains an audit committee to
supervise these matters. The Code does not elaborate on just how
the audit committee is to proceed in monitoring a company's risk
management and processes. Sound business sense will most likely
dictate that the committee diligently assess the risks of the
company, make an independent and informed decision on what the
corresponding appropriate controls and measures should be and,
finally, that the processes which are put in place on the basis of
these assessments and actions are monitored in regular intervals
and adapted to the changing risk profile of the company, if
required. Because the external auditors will also report on their
findings on this topic, the committee will ultimately also reflect
and, if necessary, act on such findings.
The external auditor's independence
Section 7.2.1 subsection 1 of the Code recommends that, before
making a proposal for the appointment of a particular external
auditor, the audit committee obtain a detailed statement from the
prospective auditor stating whether and, if applicable, which
professional services, financial and other relationships exist
between the auditor, the auditor's executive bodies and/or
representatives and head auditors, on the one hand, and the company
and members of its executive bodies, on the other hand, that could
call such auditor's independence into question. This statement must
also describe which other services, especially consulting services,
were performed by the prospective auditor for the company in the
past year as well as what services, if any, the auditor has been
retained to provide in the future.
The audit mandate, focal points and fees
In part, section 5.3.2 of the Code, which deals with the
retention of the external auditor, merely restates the statutory
rule found in section 111, subsection 2, sentence 3 of the German
Stock Corporation Act that a body other than the management board
of the company, be it the supervisory board or the audit committee
(if the company has one), retain the external auditor. However, the
Code expands on this rule by requiring that the audit committee
determine the focal points of the audit as well as review the fee
arrangements with the auditor. In addition, section 7.2.1
subsection 2 of the Code recommends that the committee agree with
the auditor that the committee chairman be informed immediately of
any grounds for the auditor's disqualification or issues of
impartiality (or, better said, lack thereof) which may arise in the
course of the audit to the extent these cannot otherwise be
resolved. Section 7.2.3 of the Code further provides that the
committee arrange for the auditor to report promptly on all facts
and events of relevance to the committee's tasks. And it continues
by recommending that the audit committee ensure that the auditor
reports any evidence of misstatements of the management board or
the supervisory board under the Code.
Constitution of the audit committee
The Code is largely silent on how the audit committee should be
constituted. It makes only two requirements (1) that the chairman
of the committee not be a former management board member (section
5.3.2 of the Code) and (2) that the members of the committee have
the requisite expertise (section 5.3.1, sentence 1 of the Code).
For companies that are also subject to foreign audit committee
rules, such as the SEC rules under the Sarbanes-Oxley Act, this
could provide the necessary flexibility to come into compliance
with both the foreign and the German rules. This will be even more
the case in light of the SEC proposed exemptions for foreign
issuers. In the case of issuers with two-tier boards, such as
German companies, the SEC is proposing to allow the supervisory
board to qualify as the board of directors under the proposed rule
and either to form a separate audit committee of outside members
or, if the entire supervisory board is independent within the
meaning of the proposed rule, designate the entire supervisory
board as the company's audit committee.
Outlook
Generally, it can be expected that most large publicly listed
companies will follow the Code's recommendations regarding audit
committees. In the case of smaller companies, however, it may be
more practical and appropriate for companies to opt out of the rule
and to have the supervisory board take on the audit committee
responsibilities, especially, as demonstrated by the proposed SEC
exemptions, if the supervisory board is sufficiently
independent.
Dr H Elizabeth Kroeger and Dr Peter Etzbach