VideoThe more things change, the more they stay the same. At least as far as audit committees are concerned. Twenty-five years ago, the Securities and Exchange Commission uncovered millions of dollars in illegal campaign contributions and payoffs to foreign governments by defense and aviation giant Lockheed Corp. Eventually, 400 or so firms were investigated for similarly questionable, "off-book" payments. One common factor: the companies' boards either did not have a functioning and qualified audit committee or had a committee of members with obvious ties to management.
Thus began the first real push for effective audit committees. In 1976, then-SEC chairman Rod Hills persuaded William Batten, the head of the New York Stock Exchange, to require that audit committees have independent directors as a condition of listing. New standards were soon adopted, though never strictly enforced. And as part of the SEC's settlement with Lockheed, the agency gave approval to who would serve on the company's new audit committee.
Today, the SEC is again pushing for improved audit-committee effectiveness; the stock exchanges are again reviewing their listing standards for audit committees; and Lockheed's successor company, Bethesda, Maryland-based Lockheed Martin Corp., has again come in for some criticism.
Buried in an SEC filing last November was the disclosure that 25 percent of Lockheed's net income for the third quarter was generated by an adjustment of accounting reserves. Although it is not unusual for defense companies to show regular accounting gains and charges, the size of this one raised eyebrows.
After a scathing article on the earnings adjustment ran in the Wall Street Journal, the stock price began to tumble. The inevitable class-action complaint alleging fraud and insider trading was filed in January.
The earnings adjustment occurred while the former CFO of Lockheed Martin sat on the audit committee. Vincent Marafino, who retired in 1995, sold some $11.2 million in stock last year and received a $250,000 annual retainer from the company for consulting services. Along with five other board members and executives, he was named a defendant in the shareholder suit.
Says Hills, who left the SEC in 1977 and is currently on the audit committees of four companies, including Oak Industries Inc. and Federal-Mogul Corp.: "After all these years, you would have thought Lockheed would have gotten it right. Nobody in good conscience could possibly think that the former CFO, particularly if he's paid as a consultant, constitutes an independent director. It's not good corporate practice. It's bizarre."
Lockheed Martin spokesman Lee Whitney counters that it was "entirely proper" for Marafino to have served on the company's audit committee, adding that the former CFO has "an unassailable reputation for integrity." Marafino's planned retirement from the board was disclosed in March.
The SEC on the Attack
Like his predecessor, current SEC chairman Arthur Levitt is vigorously pursuing companies that practice aggressive earnings management, and turning his attention to the role audit committees play. As part of Levitt's ongoing assault on accounting irregularities, audit committees have come under intense scrutiny for not providing the independent oversight of a company's financial controls and reports that investors expect.
"This is an area that cries out for adjustment," Levitt groused at a press briefing last fall, noting his concern about audit committees that hold only a few meetings a year, conduct brief and perfunctory reviews of financial statements, and include members who are unqualified or too close to management.
In turn, in February, a blue-ribbon panel of market regulators, accounting officials, and corporate executives--assembled in response to Levitt's concerns--proposed a new set of listing requirements and disclosure rules to strengthen audit committees. The 10 recommendations not only spell out a revised definition of what makes for an independent and qualified audit-committee member, but also detail new responsibilities for audit-panel members, as well as new steps for monitoring the work of the company's external auditor.
While the recommendations are still subject to approval by the SEC and other regulators, they at least set the floor for what is expected from audit committees. And some see them as a necessary deterrent. "It does seem logical and rational," says SEC general counsel Harvey J. Goldschmid, "that an effective audit [committee] process will mitigate, not eliminate, the kinds of venal accounting-fraud situations we've seen and, more important, would increase the probability that quality disclosure will take place."
Indeed, in retrospect, it's clear that some of the companies with recent accounting disasters have had dubious audit committees. All four members of the special audit panel investigating the massive fraud at Cendant Corp. had personal and financial ties to the company. The audit committee at Waste Management Inc., which was dominated by the company's former CFO, failed to review the auditor's management letter during the years that the company racked up $3.5 billion in special charges that were eventually reversed. And even though the Sunbeam Corp. board ousted CEO Al Dunlap last June, the troubled company's audit committee reported only two meetings during the fiscal year in which, it turned out, Sunbeam was artificially inflating revenues.
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