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Two years after the SEC started requiring finance experts on audit committees, it's still not clear who qualifies, or whether it really makes a difference.
Alix Stuart, CFO Magazine
September 1, 2005
See our chart on "Grading the Experts"
When the Securities and Exchange Commission began requiring companies to disclose whether or not they have financial experts on their audit committees, Costco Wholesale Corp. board members did not sweat the process, recalls CFO and board member Richard Galanti. They simply asked their audit-committee chairman, Charles Munger, to consider accepting the title. He agreed.
"I don't think there was a lot of magic to it," says Galanti. As president of Berkshire Hathaway–owned Wesco Financial Corp. and sidekick to Berkshire CEO Warren Buffett, Munger easily fit the SEC requirements for the role, which had broadened out over the rulemaking process. And although one member may have been designated the expert, says Galanti, "we feel all the members of the audit committee add to the process. [Munger] provides his full share of comments," he adds, "but the other two aren't sitting around doing nothing."
Two years ago, the SEC was hoping for a little magic with its new disclosure rule. At the time, it seemed like a promising way to guarantee audit committees would detect accounting fraud more effectively than their counterparts had at the likes of Enron, WorldCom, and Adelphia. Few companies would want to be caught without an expert, the thinking went, and so they would hire in new talent — namely, CFOs and former audit partners—to shake up their audit committees.
Today, it's not apparent that the rule has changed disclosure or governance in any meaningful way. While nearly all Fortune 500 companies claim to have an expert, according to CFO's review of their proxy information, more than half of the approximately 850 people named as experts are the archetypal board member: a current or former CEO. Persons fitting the "ideal" remain few and far between. About 16 percent were formerly CFOs, while 8 percent were once public auditors. Only 7 percent — 63 people — are current or recently retired finance chiefs.
Of course, titles can be deceptive. The CEO at one company may be more financially savvy than the CFO at another, while a long-retired executive may have rustier skills than a former title would imply. However, the companies reviewed by CFO do not even attempt to convince shareholders that their experts meet the SEC's requirements, relying instead on generic biographies and boilerplate disclosure language. "In many cases, it's far from clear why a particular individual meets the letter and spirit of the SEC law," says Joseph Carcello, director of research for the University of Tennessee's Corporate Governance Center. "In the interest of transparency, shouldn't we be able to tell if they meet the requirements?"
To that end, CFO did its own rating of the Fortune 100's experts, based on additional research that included calling companies to ask for justification of experts with ambiguous qualifications. While those ratings paint a fairly bright picture — 26 companies had at least one expert who rated an A, while only 9 companies got Fs — the qualifications of many experts remain a mystery. Says Carcello: "It makes a skeptic ask, 'Are companies not disclosing the information because their experts don't have the right backgrounds?'"
What's more, there seems to be little incentive for companies to step up their efforts. Many agree with Galanti's assessment that the expert is indistinguishable from other audit-committee members. "In my experience, I have not found a particular burden as a financial expert," says retired AT&T vice chairman (and former CFO) Charles Noski, who is Microsoft Corp.'s audit-committee chair and one of two financial experts on the committee. Governance experts "look at a lot of different indicators [to assess the quality of audit committees], but we see no evidence that [designating a financial expert] is a significant one," adds Nell Minow of corporate-governance research firm The Corporate Library. Even the SEC doesn't seem to care. While its reviewers check for the disclosure statement, "there's no qualitative analysis of the disclosures," says a source familiar with the process.
Creating a Gray Area
Some believe the rule was doomed to fail from the start. Section 407 of the Sarbanes-Oxley Act of 2002 directed the SEC to require public companies to report annually whether they have an audit-committee "financial expert," a term the SEC was also supposed to define. In its initial definition, the SEC said an expert should have past experience preparing or auditing financial statements, among other criteria, thereby making CFOs and auditors about the only folks who could fit the bill.
By the time the rule was finalized, however, corporate complaints had broadened the definition so that sages like Alan Greenspan and Warren Buffett — along with nearly anyone else who had ever touched a financial statement — could theoretically qualify. (Buffett is on Coca-Cola's audit committee but is not its designated expert, while Greenspan gave up his board affiliations when President Reagan appointed him to the Federal Reserve Board in 1987.)
"The standard is somewhat loose," says Peter Gleason, director of research at the National Association of Corporate Directors, in Washington, D.C. The only guidance the SEC provided was that an expert must have five attributes, including an understanding of GAAP and the ability to assess the application of its principles, along with experience "preparing, auditing, analyzing, or evaluating financial statements...or experience actively supervising someone engaged in that activity."
The latter phrase, a key change between the proposed and final rules, allowed people who were several degrees removed from the actual issuance of financial statements, such as investment bankers, venture capitalists, and CEOs, to fill the role. The final rules also absolved companies of having to provide the rationale for their choices, making it easy for companies to follow form without content. Moreover, the duties of the financial expert were never spelled out, creating little accountability.
Who Fits the Bill?
Absent any SEC enforcement actions or additional guidance related to Section 407, what passes for financial expertise leaves a lot to be desired, say corporate-governance experts. If he had his druthers, Roman Weil, a professor at the University of Chicago Graduate School of Business, would insist that accounting experience be the key requirement, since the main charge for the audit committee is to oversee auditors. "Suppose you're on the audit committee of a company that does a lot of foreign-exchange transactions," says Weil. "You wonder, is my company hedging, or are they speculating? How could you tell? You'd have to understand accounting just to think about it."
Weil's theory is backed by his research, including a recent study of 300 Fortune 1,000 audit committees that ranked people with experience as public accountants and controllers higher than CFOs and investment bankers. In that study, he and colleagues Douglas Coates and M. Laurentius Marais found that companies that added people with accounting expertise to their audit committees between 2000 and 2004 averaged a 4.6 percent higher stock price than companies that did not. This finding echoes research by Mark Defond, Rebecca Hann, and Xuesong Hu, all at the University of Southern California's Marshall School of Business, which found that companies with accounting experts on their audit committees enjoyed an average 1.3 percent stock-price premium compared with other companies.
Others argue that the CFO is the ideal candidate for the title of financial expert. "A CFO who has been heavily involved in the whole spectrum of his own financial reporting would be among the best people to meet the financial-expert requirement," says H. David Sherman, a professor at Northeastern University who was an SEC accounting fellow until August. "CFOs are the ones who have to try to understand everything, from multiple perspectives."
E. Peter McLean, vice chairman and global leader of the financial-officer practice at Spencer Stuart, who has completed more than 100 financial-expert searches during the past two years, agrees. The large global companies he works for "are looking for financially literate professionals who have been exposed to technical accounting and reporting at a detailed level, and to a broad range of risk issues, including capital-markets transactions involving hedging and derivatives," he says.
In practice, Noski, who has been a Big Four partner, corporate controller, and chief operating officer, as well as a three-time CFO, says he draws on his CFO and COO experience more than anything else in serving as audit-committee financial expert for Microsoft. It's not that the accounting is irrelevant, but that it is inherent in the CFO role. "It would be hard to be [finance chief] of a public company these days and not have a pretty good sense of accounting, even if you haven't done it before," he explains.
In its final rules, the SEC said specifically that experience as an auditor, CFO, controller, or even chief accounting officer "does not, by itself, justify the board of directors in deeming the person to be an audit-committee financial expert." Boards are also expected to consider the person's integrity, as well as any disciplinary actions he or she may have faced.
The final SEC rulings do stipulate, however, that CEOs do not automatically qualify. While a CEO who actively supervised a CFO may be within the bounds of the rule, the SEC cautioned that the term "active supervision" means more than the mere existence of a traditional hierarchical reporting relationship. The SEC also asserted, "A principal executive officer with considerable operations involvement but little financial or accounting involvement likely would not be exercising the necessary active supervision."
Of course, CEOs may well have skills to contribute to audit committees. But they generally "haven't gotten down to the level of granularity in GAAP that you sometimes need," says Christine Russell, CFO of OuterBay Technologies and audit-committee financial expert for Peak International and QuickLogic. "CEOs tend to look at financial statements with more of an eye toward performance." Adds Carcello: "I'd be skeptical that a CEO who just oversaw finance really qualifies."
Rating the Reality
Ideals aside, what are the qualifications of the named financial experts? Proxy statements provide few answers, despite the fact that Section 407 was essentially a disclosure requirement. In its most recent statement, Dow Chemical, for example, chronicles the illustrious marketing career of one of its experts, Whirlpool CEO Jeff M. Fettig, but provides no clues about his financial expertise. Past University of Pennsylvania president Judith Rodin, an expert in psychology, appears as a financial expert for Citigroup with no mention of any financial experience. (Citigroup said it had no further information on Rodin or any of its other named experts.) A number of companies, including United Technologies Corp. (UTC), listed multiple chairmen and CEOs as financial experts without explaining how they meet the SEC requirements. (When contacted, company spokesman Paul Jackson said the designation of UTC's four experts was based on their having "actively supervised financial and/or accounting functions during their careers.")
In their defense, some companies say that the audit committee's role is more than just overseeing the auditors. "For us, the audit committee doesn't just look at accounting issues," says WellPoint Inc. CFO David Colby. "It looks at capital structures, all of our financings, our investment portfolio for our insurance side — so even in the area of finance, you almost need sub-specialists." While he finds it "incredibly powerful" to have a current CFO — Ramiro Peru of Phelps Dodge Corp. — along with two former CFOs among Wellpoint's five financial experts, Colby says the two other members are just as valuable. Fifth Third Bancorp CEO George Schaefer "runs a financial institution, so he understands financial instruments and covenants," says Colby, while Mays Chemical Co. CEO Bill Mays "started his own business virtually from scratch. You can't be a good entrepreneur if you don't have a strong financial background."
In other cases, the designated experts have the standard finance and accounting experience; it just isn't mentioned in the proxy. Neither Intel nor Goldman Sachs bothers to mention that Lord Edmund John Browne was the CFO of Standard Oil Co. and BP America in the 1980s when they list him as a financial expert. Browne's short biography notes only his current positions as managing director and group CEO of BP Plc. Both IBM and Altria neglect retired Mobil CEO Lucio Noto's experience as CFO of Mobil Corp. Verizon leaves out Deere Co. CEO Robert Lane's background as CFO of the heavy-equipment manufacturer, and declines to provide any additional information on its four other financial experts, most of whom are CEOs with no clear finance experience.
A Check-the-Box Activity
Given the paucity of information, CFO contacted Fortune 100 companies whose boards lacked obvious finance experience. Using that data, CFO graded the boards according to criteria corporate-governance experts believe the SEC should have required, based on the expert with the clearest qualifications. We found that nearly half of the companies required to disclose their experts — 45 out of 93 — name someone who served as a financial executive at some point in his or her career, meaning most have at least one board member with a background the SEC should have required. Companies were not penalized for additional experts with fuzzy qualifications, however, so that many with multiple experts were able to score high even if some of their experts were not clearly qualified.
Most companies contacted by CFO ask all board members each year about their ability to meet SEC requirements. "It's essentially a self-designation, but with a little bit of information to support it," says J. Michael Cook, a former Deloitte & Touche CEO who chairs audit committees for Comcast and International Flavors & Fragrances and sits on audit committees for Dow Chemical and Eli Lilly. Usually companies then send the information to their corporate-governance or nominating committees for the final decisions about who qualifies, with status quo generally reigning supreme absent director resignations or other extenuating circumstances.
Once experts are chosen, companies rarely test their experts' self-reported knowledge. "Given the people I deal with, I don't see a need to give everyone a 20-question exam," says Cook. "It's not a bad idea, it's just not necessary." Instead, say those who work with audit committees, the back-testing often occurs in the annual self-assessments that each board committee does, which would allow for problem directors to be reported to the nominating committees.
Companies struggle with how many audit-committee financial experts to designate. CFO's analysis found that just over half of the Fortune 500 named only one expert, while the remaining 222 had multiple experts. Of those, 58 count three experts, 39 had four experts, 13 had five, 8 companies counted six, and 1, Goldman Sachs, had seven.
Constellation Energy is among those that named only one expert — in this case, former Arthur Andersen partner James T. Brady. "We've taken the most conservative position and haven't asked the nominating/corporate-governance committee if any of the other members of the audit committee would qualify as financial experts, because that's not required," says Charles Berardesco, the company's corporate secretary and managing attorney.
Other companies veer toward excess. WellPoint, for example, names all five of its audit-committee members as experts. "All of these people have financial expertise," says CFO Colby. "That's one reason they're on the committee."
More companies are taking WellPoint's approach, in part to hedge against sudden resignations and in part to avoid a one-voice audit committee. "In general, an audit-committee chair would prefer more than one financial expert, in order to foster debate," says McLean of Spencer Stuart.
Half Empty or Half Full?
At this juncture, is the "financial expert" an empty designation, or simply underutilized? Although few can quantify the value added by the designation, many believe it has helped meet the main goal of Section 407: to make audit committees more tenacious. "Certainly, the role of the audit committee has much improved over the past two years," says Costco's Galanti. Munger, along with his counterparts, now pushes management to "worry not just about what's required, but also about where we can be surprised." Constellation's Berardesco agrees. "I'm not sure [the designation] is as important for shareholders," he says, "but it does focus the board in looking at the audit committee."
Few boards are willing to be caught without one, in fact. The number of S&P 500 companies disclosing experts shot up from 21 percent to 91 percent between 2003 and 2004, according to Spencer Stuart research, while financial-expert searches made up 11 percent of all board searches in 2005. "Most boards these days don't feel comfortable unless they have someone grounded in the technical skills," McLean says. "They are looking for someone who is not going to be fooled — whether or not they are the designated financial expert."
Ultimately, though, the worth of the financial-expert designation remains to be seen. "Audit committees are working harder and paying more attention," says The Corporate Library's Minow. "But only time will tell if they're more effective."
Alix Nyberg Stuart is senior writer at CFO. Additional research was provided by Laura deMars.
See our chart on "Grading the Experts"
In the Crosshairs
Could financial experts be more vulnerable to liability?
Higher liability for the financial expert was a key concern when the rule was first written. "People tell me it's like wearing a target on my chest," says former Deloitte & Touche CEO J. Michael Cook, who chairs audit committees for Comcast and International Flavors & Fragrances and sits on audit committees for Dow Chemical and Eli Lilly. But to date no one with the designation has been hit with a lawsuit.
To assuage some of the initial concerns, the Securities and Exchange Commission noted in its final rule that the expert should not be considered more responsible than any other member of the audit committee. That move, plus state laws regarding director responsibilities, created a two-tier protection, say legal experts. Moreover, shareholder lawsuits have historically not even distinguished the audit committee from the rest of the board.
Still, Brian Pastuszenski, senior partner in the securities litigation and SEC enforcement group of Goodwin Procter LLP in Boston, expects that "plaintiffs will try to argue that these people should be held to a higher standard. But I won't say that's what's going to happen."
Those who have been designated financial experts, however, say they're not concerned. "I don't spend a great deal of time worrying about it," says Cook. Besides, says Peter Gleason, director of research at the National Association of Corporate Directors, "no one is going to take on that moniker of financial expert unless they truly believe they qualify. Why would you, given the litigious society in which we live?" — A.N.S.