Risk & Compliance

Membership Has No Privileges

In the wake of the Enron scandal, shareholders are tightening the screws on audit committees. Now all they have to do is find executives who are wi...
Marie LeoneFebruary 28, 2002

In 16 years of professional basketball, Julius Erving never had trouble controlling the boards. As a member of the New Jersey Nets, and later the Philadelphia 76ers, Dr. J dominated the glass with his sweeping offensive rebounds and above-the-rim acrobatics.

These days, Erving may not have such an easy time of it with boards. Since retiring from the NBA in 1987, Dr. J has parlayed his fame—and business acumen—into a nice career as an executive ambassador and entrepreneur. But fame and business acumen have also landed Erving on the audit committees of two corporations—Saks Inc. and Darden Restaurants Inc.

And that puts him squarely in the line of fire. In the wake of Enron and other accounting snafus, board directors and their audit committees now face intense scrutiny from regulators, lawmakers, institutional investors, and corporate governance advocates. That goes double for high-profile or celebrity directors, who can expect something akin to a full-court press from shareholder activists. “Companies should consider board members with corporate finance or Wall Street experience,” argues institutional investor Bert Denton, “rather than wooing former senators.”

Sit and Rotate

Denton is not alone in his thinking. At the very least, corporate stakeholders, hell-bent on curbing corporate financial failure, will spend the next year meticulously reevaluating the makeup of audit committees, which are typically comprised of a company’s directors. Shareholders will also be taking a long, hard look at the financial literacy and independence of board members.

Congress will be doing the same thing. With corporate bankruptcies and financial restatements making the front page on a nearly daily basis, legislators are feeling pressure to do some legislating. But Capitol Hill—watchers say it’s unlikely Congress will act on any new corporate accounting laws until after the first week in November. It’s an election year, and reform—especially when linked to the biggest financial scandal in history—is a contentious, often emotional issue. Politicians don’t want to end up on the wrong side of the debate as voters head to the polls.

The delay in passing new statutes is probably good news, says Bob Williamson, CFO at Boca Raton, Florida-based investment bank vFinance Inc. and a former audit committee member of Equinox Inc. Williamson doesn’t think heaping new rules on audit committees is the answer. “The rules are already in place; we just have to figure out how to enforce them effectively,” says Williamson. “When someone runs a stop sign, you don’t change the law, you enforce it.”

It’s likely that proactive shareholders will ask audit committee members to do much of the policing. Given Enron’s spectacular collapse, observers say a number of institutional investors now want audit committees to examine off-balance-sheet transactions and special purpose entities. Many shareholders would also like boards to start deciphering those complicated footnotes often buried in the back of financial filings and annual reports.

Some governance activists go even further, promising to take a stick to the structure of audit committees. Sandy Winer, a partner at law firm Foley & Lardner and a former SEC attorney, says that several measures have already been submitted by stakeholders that would dramatically alter who sits on audit committees—and for how long. One group, he notes, is pushing for a mandatory rotation of external auditors and internal audit committee chairs.

That would be a big change. At some companies, being named audit committee chair is practically a lifetime appointment. Enron’s audit committee chair, for instance, served almost 25 years.

Pick of the Literate

If shareholders are keen on limiting how long directors serve on audit committees, the SEC wants to make sure they belong in the boardroom in the first place. The commission has already passed a rule mandating that audit committees consist of not less than three directors, all of whom must be “financially literate.” What’s financially literate? Being able to read and understand fundamental financial statements, says the SEC. The new rule also stipulates that at least one of the three members of an audit committee, usually the chair, must have specific finance or accounting employment experience.

Given such a requirement, executives and shareholders may have little choice but to court finance types for directorships. In fact, managers at executive search firm Christian & Timbers already report a dramatic shift in client requests. They say they’ve seen a 50 percent rise in requests for board member candidates who possess strong financial backgrounds—or CFO experience. Jeffrey Christian, CEO of the search firm, attributes the increase to the SEC’s new rules and the fiasco in Houston. “Enron has taught everyone that the audit committee is the most important committee of the board,” says Christian.

Several institutional investors are also eager to get finance executives on corporate boards. Denton, who founded investment firm Providence Capital, believes big investors should sponsor director nominations to ensure that a board is not simply made up of cronies of the executive committee. Last year, Providence submitted alternative director slates to two portfolio companies: ICN Pharmaceuticals and Trover Solutions Inc., formerly Healthcare Recoveries Inc.

All told, Providence has submitted a total of 16 alternative slates over the past five years—and placed 19 of its nominees on 11 boards. Still, Denton concedes that the average institutional investor doesn’t delve too deep into governance issues. Why? “Because the process is contentious, often litigious,” says Denton. “Portfolio managers would rather spend their time buying and selling stocks, not giving depositions.”

So Who Would Want This Job?

CFOs may have similar feelings. The sudden surge in interest in audit committees—not to mention the sudden surge in interest in suing companies—has some committee candidates balking. “Recruiting directors for the audit committee is like calling them on deck for a kamikaze attack,” says vFinance’s Williamson. Indeed, one of the biggest challenges corporate officers will face this year is convincing highly qualified executives to accept directorships and audit committee nominations.

Admittedly, personal liability is nothing new to corporate directors. They are aware of, for example, payroll tax reporting requirements. But this time around, directors and audit committee members could find themselves tangled up in bankruptcy and shareholder lawsuits. Williamson says potential committee members would be wise to carefully examine directors and officers (D&O) insurance policies to make sure there’s sufficient coverage.

Even that might not help. As CFO.com reported last week, two of Enron’s liability insurers, The St. Paul Mercury Insurance Co. and Royal Insurance Company of America, claim that fraud charges leveled against Enron effectively abrogate the company’s D&O policies. Peter Taffae, CEO of wholesale underwriter e-perils.com, isn’t convinced the two insurers are off the hook, however. Taffae says that fraud exclusions only kick in if a company is actually convicted of fraud—not just charged with it. And he notes that more than 80 percent of D&O claims cases are settled before they reach a jury.

Taffae does point out, however, that committee members do face some real perils these days—particularly if a company they audit ends up going bankrupt or gets entangled in a financial scandal. The biggest worry for board members: not having enough D&O coverage. Recent press reports, for example, set Enron’s total liability insurance at $435 million. But Taffae doesn’t think that’s enough to cover all the lawsuits. He points out that the second-largest corporate financial scandal to date—the fraud charges leveled against Cendant Corp.—ultimately cost $2.8 billion in security litigation costs.

Insurance experts also note that, since most D&O policies are written to cover litigation costs associated with individuals and/or a company in aggregate, creditors and shareholders can quickly deplete the “entity” coverage. That can leave directors with little protection against individual suits. One way out of the indemnity mess, notes Taffae, is for companies to buy a “side A only” policy that only covers individuals. Corporations can cut the cost of such a policy by layering it on top of all other coverage.

For his part, attorney Winer thinks the SEC should consider setting up a safe harbor for audit committee members. He believes many potential committee members will now need some convincing to sign on with a company. By his lights, Winer believes the commission should set guidelines that detail what is expected of audit committee members. If the directors do the right thing, then he believes they should be shielded from lawsuits.

No Horse Heads, Please

In theory, doing the right thing should not be all that tough. “You don’t have to be a CPA or understand the intricacies of the Financial Accounting Standards Board rules to sit on the audit committee,” declares Nell Minow, the famed corporate governance activist. “But you do have to have common sense and the courage to do what is expected of you.”

You also need to know what’s going on at a company—and therein lies the rub. Minow recalls an instance in which a lower-level company accountant was fired before she could meet with the audit committee because the junior staffer criticized the company CFO’s accounting practices. The finance chief was eventually fired.

While avoiding that sort of scenario could prove nearly impossible, Minow says audit committee members must be firm in their demands. If members of a company’s audit committee read about a problem at that company in a newspaper—rather than hearing about it first from senior management—she believes those managers should be fired. In fact, when it comes to reporting to the audit committee, she says senior corporate officers should be required to follow the Godfather approach. And that is? As Robert Duvall said in the movie, “Mr. Corleone is a man who insists on hearing bad news immediately.”