Board games: board reform is essential. Too bad it may backfire – The State of Finance: Corporate Governance
FORMER ENRON CFO Andrew Fastow is by all accounts a persuasive personality but that doesn’t explain why Enron’s board of directors failed to raise even the smallest red flag. Not once did it voice an objection to any of management’s accounting practices, according to a Senate subcommittee investigation, despite repeated warnings from Arthur Andersen auditors that those practices were “high risk.” Shockingly, the board even waived its own conflict-of-interest guidelines to allow Fastow to set up off-balance-sheet partnerships that profited at the expense of Enron’s shareholders.
In short, corporate governance failed abysmally at Enron, just as it failed at a number of other scandal-plagued companies in recent years, from Tyco International to WorldCom to Adelphia. As a result, the confidence of investors in the capital markets has been badly battered–along with their wallets–and reformers on Wall Street and Capitol Hill are trying to do something about it, by enacting the most sweeping agenda of corporate-governance reforms in 70 years.
The reforms–as embodied in the Sarbanes-Oxley Act of 2002, and in proposed guidelines from NASD–aim to make corporate boards more independent and knowledgeable, and thus a stronger check on corporate management. Indeed, by giving boards and audit committees greater responsibility for monitoring the actions of senior executives, the reforms may signal a radical rebalancing of corporate power.
“We’re moving away from the imperial CEO model,” comments William Allen, director of New York University’s Center for Law and Business. “In the past, we have had powerful CEOs and passive boards of directors. If the CEO is good and honest, it’s probably the most productive business model. If he’s not, you can have a disaster.”
But some observers question whether the new corporate-governance rules can prevent managerial shenanigans and the disasters they have caused. After all, in terms of knowledge and independence, Enron had an exemplary board of directors in the summer of 2001–at least on paper. Its members included CEOs, lawyers, academics, and former regulators. The chairman of the audit committee was the former dean of the Stanford Graduate School of Business. And only 2 of the 17 members, Enron’s then-chairman Kenneth Lay and then-CEO Jeffrey Skilling, were insiders.
At the same time, the new rules may make it harder for companies to recruit effective board members, say critics. In the worst case, newly empowered boards may subject management to crippling second-guessing. “If you start to gut management’s ability to make decisions and bet on the future, they can’t compete,” warns Harold Bradley, president of Kansas City, Missouri-based American Century Ventures, a unit of investment-management firm American Century Investments.
UNBINDING THE TIES
Independence is the main theme of the NYSE and NASD rules, which have yet to be approved by the Securities and Exchange Commission. They mandate that all listed companies have a majority of independent directors on their boards. The rules also considerably tighten the definition of independence. An independent director can have no material relationship with the listed company other than in his or her role as director, and companies must disclose how they arrived at that determination in proxy filings. The requirement means no commercial or industrial relationships; no family ties to management; no professional-services contracts to perform banking, consulting, accounting, or legal work for the company. The rules also require a five-year “cooling-off period” before former employees or auditors of the company can be designated independent directors.
Furthermore, under the new listing requirements, independence is required of all the directors on the committees overseeing auditing, compensation, and board nominations–arguably a board’s three most important spheres of responsibility. “These changes alter the whole dynamic of the board,” says Charles Elson, director of the Center for Corporate Governance at the University of Delaware. “There’s now less threat of being replaced if you don’t follow the CEO.” As for directors’ own compensation, the NYSE’S rules advise companies to “be aware that questions as to directors’ independence may be raised when directors’ fees and emoluments exceed what is customary.”
Viewed from the perspective of the new rules, Enron’s board wasn’t as disinterested as it seemed. Directors were compensated handsomely for their trouble, receiving some $300,000-plus annually, and a number had financial ties to Enron. By contrast, according to a recent survey by CEO magazine of senior finance executives at 81 public companies, most directors are paid no more than $50,000 a year (see survey, page 36).
Of course, demands for greater board independence aren’t new. The Walt Disney Co., for one, has been criticized for years for having too many board members with ties to CEO Michael Eisner, whose stratospheric compensation in the past six years or so has belied the disappointing performance of Disney’s stock. What’s more, many of the new board proposals were issued as recommendations by an SEC-convened blue-ribbon panel on audit-committee effectiveness four years ago. In fact, many companies were recruiting more independent directors for board positions long before the Enron debacle. “There’s been a lot of attention paid to this in the last couple of years,” says Dennis Beresford, a former chairman of the Financial Accounting Standards Board who now teaches at the University of Georgia.
“We don’t need to change our board in terms of its independence,” says R. Foster Duncan, CFO of Cinergy Corp., a Cincinnati-based diversified energy company. Eight of Cinergy’s nine board members would currently meet the heightened standard for independence as proposed by the exchanges. Likewise, National Semiconductor has an eight-member board, with CEO Brian Halla being the only nonindependent director.
Even so, the CEO survey indicates that more than a few companies would have a long way to go to meet the new independence requirements. The survey found that more than 20 percent of the respondents had less than a majority of independent directors on their boards, and that more than a third lacked totally independent audit committees.
The issue of independence is clearly gaining currency among investors. HealthSouth and IDT recently joined Disney as objects of scrutiny because of their lack of it, and the list is likely to lengthen. “Some boards are well ahead of others on this, and won’t have a lot to do. Others will have to change dramatically,” says Beresford, who was elected to the WorldCom board in July and sits on two other public-company audit committees.
The changes may eventually raise the issue of whether the roles of CEO and chairman of the board should be kept separate, as is typically the case in Europe. “The NYSE rules don’t mandate it, but the independent directors will be meeting on their own more frequently, and it’s natural that a leader will emerge,” says NYU’s Allen. And that leader could provide a counterbalance to the CEO, though studies that attempt to analyze the effect of having separate board chairmen and CEOs in the United States and Europe have so far been inconclusive (see “Transatlantic Answers,” October).
IN SEARCH OF NUMBER CRUNCHERS
Corporate directors will not only have to be more independent in the future, they will also have to be smarter-particularly those serving on the audit committee. Previously, exchange rules regarding “financial literacy” were broad enough that virtually anyone with a little business experience could qualify. Sarbanes-Oxley, however, recommends that at least one financial expert now sit on the audit committee and that such an expert have experience either preparing or auditing financial statements. If the committee does not have such a director, the company has to explain why in its proxy statement.
In the past, audit committees have often leaned on one person with deeper knowledge of financial statements to shoulder much of the oversight role, says Olivia Kirtley, a retired CEO who chairs the audit committees of one Amex-listed company, Lancer Corp., and two Nasdaq-listed companies, ResCare and Alderwoods Group. But while 8 in 10 of the CFO survey’s respondents say the level of financial expertise on their audit committees is “good” or “excellent,” almost half report that their committees need even more expertise.
They will certainly be putting in more hours. Informal surveys by the National Association of Corporate Directors suggest that board members now expect to spend between 175 and 200 hours per year on board business, versus 100 to 125 hours in the recent past. The committees’ workload, in fact, has already increased dramatically during the past several years, and one “financial expert” may not be enough. “With the complexity of transactions, new financial instruments, and off-balance-sheet items, audit committees need more knowledgeable people–and they need more than one” per committee, says Kirtley. That demand, of course, may also make such experts harder to come by.
Some companies have taken the initiative by educating their board members. Cinergy, for example, has set up a series of training sessions on accounting and finance topics, including wholesale energy trading–an activity that has landed more than a few energy companies and utilities in hot water. The company has also set up an Internet-based system, called Board Vantage, that gives directors access to financial information and interactive tools to communicate with external auditors, management, and legal counsel. “It helps them to be more prepared for board meetings and to fulfill their responsibilities,” says Duncan.
Audit-committee members also have independent access to the company’s external auditor, Deloitte & Touche; its internal auditor, PricewaterhouseCoopers; and its outside counsel, Skadden Arps. The committee chairperson, Mary Shapiro, head of regulation in the Nasdaq market, can engage other outside advisers if she deems it necessary. With three directors having retired in May, Cinergy may be looking to bring on new board members. “There’s a lot more competition for a reduced number of people, and we think to the extent that we have good governance practices in place, it will improve our ability to recruit new people,” says Duncan.
Not surprisingly, the individuals in greatest demand for corporate-board duty are former audit partners and retired CFOs. “We’re seeing a lot more boards searching for CFOs,” says Roger Raber, president of the NACD. With many of the approximately 45,000 directors of public companies expected to turn over in the next 12 months, finding financial experts won’t be easy–particularly in view of the increased hours that directors will have to work to fulfill their responsibilities. Add in the fact that boards are almost universally asking their senior executives to reduce their obligations to outside boards, and the hunt for financial talent is getting intense.
“The number of board searches we’ve performed for people with financial acumen in the last nine months is astounding,” says Peter Crist, vice chairman of executive recruiting firm Korn/Ferry International (see sidebar, page 40).
DEALING WITH AUDITORS
The most significant new role intended for the audit committee concerns the company’s dealings with outside auditors. The Sarbanes-Oxley Act goes along way toward reducing the audit firms’ conflicts of interest and monitoring the quality of their work (see “No More Mr. Nice Guy,” September). But it, along with the exchanges’ new listing requirements, also aims to break up the often too-cozy relationship between auditor and manager by putting the audit committee more squarely in the middle of the two. To that end, the new rules require audit committees to meet privately with internal and external auditors at least every quarter–something dominant CEOs like Jack Welch discouraged in the past. Indeed, 64 percent of the respondents to the CFO survey say their audit committees are influenced to some degree by the chief executive.
The audit committee will also be expected to review all significant accounting policies with the auditors, discussing which alternatives under generally accepted accounting principles were considered and which the auditor favored. They will also be required to draft a new charter detailing these responsibilities.
The increased communications with auditors will not only improve the audit committee’s understanding of financial disclosures but also prevent members from pleading ignorance about the company’s accounting practices down the road, which would potentially subject them to greater legal liability if things go wrong. From the auditors’ perspective, the dialogue hopefully will increase the chance that they can flag aggressive accounting practices.
“Auditors have always felt engaged by management,” says the University of Delaware’s Elson. “Now they’ll have more impetus to take things to the audit committee.”
What impact all this will have on a company’s ability to recruit audit committee members remains to be seen. Ditto for the effect on reporting practices themselves. Many observers believe the new audit committee rules will result in more conservative accounting, at least regarding such issues as revenue recognition and asset valuations. “I think boards as well as managers will say, ‘Why take the risk?'” says Renee Hornbaker, CFO of Irving, Texas-based Flowserve Corp., which provides pumps, valves, and other products and services to the flow-management industry.
The audit committee will also be responsible for preapproving all nonaudit services provided by a firm’s auditors. Sarbanes-Oxley identifies eight such services, including IT consulting, internal audit, and actuarial work, that auditors will no longer be allowed to provide for their clients. The audit committee will also have the discretion to prohibit any service not explicitly listed in the act. The granddaddy of them all is tax services, which probably represent the largest source of nonaudit revenue for the accounting firms. While tax work is not on the list of prohibited services, some companies are already choosing to engage separate providers for audit and tax work.
“Auditors shouldn’t audit their own work,” says Robert Ryan, CFO of Medtronic Inc., a medical technology firm based in Minneapolis. “If PricewaterhouseCoopers [Medtronic’s auditor] comes to us with a tax idea, we won’t let them implement it,” he says. “We want another set of eyes looking at it.” Fully 39 percent of the CFO survey respondents said they expect to change their relationship with external auditors in the near future. And an independent, well-informed audit committee would likely be at the forefront of the change.
But as the failure of Enron’s board demonstrates, independence and expertise don’t necessarily translate into the capacity and inclination to take directorial responsibilities seriously. As critics see the question, it’s not independence or financial acumen that defines a good director or a good board, but commitment. “We need directors to be active, healthy skeptics,” says Elson. “The board is there to monitor, not just to nod approval.”
Whether the new requirements will produce such boards is another matter. And even if they do, boards won’t necessarily prevent most abuse. Even active, healthy skeptics can’t ferret out all fraud and expose all financial misrepresentation. “We have to be realistic about what conscientious businesspeople can do working on a part-time basis,” says NYU’s Allen. To raise expectations of better governance and fail to deliver may serve only to diminish what confidence remains.
RELATED ARTICLE: A Beautiful Friendship? The CFO Corporate Governance Survey
IN THE LAST OF A SERIES of four surveys on corporate finance practices, CFO magazine E-mailed questionnaires to senior finance executives about their boards of directors. Eighty-one responded from public companies, and their answers are presented here.
The survey respondents represent a broad cross-section of industries and company sizes. Most are from companies with at least $100 million in revenues, and the most-represented industries were financial services and technology. A survey highlight: more than a third lack totally independent audit committees.
The first three surveys in the “State of Finance” series, on financial reporting, auditor-client relationships, and investment banking, respectively, appeared in the July, August, and September issues of CFO.
1. Are you a member of your
2. Are you a director on another
company’s board? How many?
More than 3 0%
3. Approximately what percentage of
your company’s board is independent?
4. How would you describe the level
of finance expertise on your board?
Very Poor 0%
5. Do you believe your board needs more
directors with financial expertise?
6. Will the tighter definitions of
independence recently issued by
the stock exchanges force you
to recruit new board members?
7. Approximately what percentage of your
company’s audit committee is independent?
8. How would you describe the level
of finance expertise on your board’s
Very Poor 1%
9. Do you believe your audit committee needs
more directors with financial expertise?
10. Will the tighter definitions of
independence recently issued by the
stock exchange force you to make changes
to your audit committee?
11. How many times did your
audit committee meet in 2001?
1 to 2 12%
3 to 4 47%
5 or more 41%
12. How many times has your audit
committee met this year (as of October)?
5 or more 39%
13. How influential is the audit-committee
chair at your company?
Very influential 34%
Somewhat influential 50%
Not at all influential 12%
Dont know 4%
14. To what degree is the audit committee
at your company influenced by the CEO?
Very influenced 13%
Somewhat influenced 51%
Not at all influenced 32%
Don’t know 4%
15. Do you believe a strong audit
committee can help a company identify
and prevent accounting fraud or
16. How much are your directors paid annually?
Less than $25,000 42%
More than $100,000 5%
Note: Totals may exceed 100 percent because of rounding.
Note: Table made from bar graph
FINDING PEOPLE TO SERVE on corporate boards used to be a snap. But now that directors are expected to treat their work as responsibility and not an honorific, the job is getting harder to fill. Christian & Timbers, an executive-search firm, expects that as many as half of all directors at Fortune 1,000 companies could turn over in the next year.
The extra time and effort involved in serving on boards isn’t so much the issue in recruiting and retaining directors; rather, it is the potential liability. “The question of director liability is not very clear under federal law,” says William Allen, director of the New York University Center for Law and Business. “The case law hasn’t growled yet, but the judges’ speeches are worrying.”
That’s particularly true in the Seventh Circuit. On June 6, a federal appeals court in Chicago reversed a lower-court decision to dismiss a lawsuit against directors of Abbott Laboratories, a manufacturer of medical products. The company began undergoing Food and Drug Administration inspections of a manufacturing unit in 1993, and after repeatedly failing to correct problems with it, Abbott ultimately paid a fine of $100 million and was forced to scrap $250 million worth of products. The shareholder suit alleges that directors breached their duty by taking no action to comply with the FDA directives despite repeated warnings.
Normally, the business-judgment rule would protect directors who make business decisions in good faith, and the lower court decided as much. Judge Harlington Wood Jr. of the appeals court, however, called the board “grossly negligent in failing to inform themselves,” and ordered that the suit go to trial.
If the Abbott directors are ultimately found liable for their failure to act, it could give directors and potential directors all the more reason not to serve on corporate boards. “When something goes wrong, people will try to find intent,” suggests Olivia Kirtley, who serves as audit chairman for three public companies. “There’s going to be a lot of Monday-morning quarterbacking.”
And quite possibly a lot more difficulty finding backups.
ANDREW OSTERLAND (ANDREWOSTERLAND@CFO.COM) IS A SENIOR EDITOR AT CFO.
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COPYRIGHT 2002 Gale Group