Independent Experts Emerge as the Board's Best Friend
from January/February 2003
by Julie Connelly
A frost is forming over the once-warm relationship between directors and the CEO—thanks in part to a provision in the Sarbanes-Oxley Act.
The chill comes from various directions. For example, section 301.5 of the new law reads, “Each audit committee shall have the authority to engage independent counsel and other advisors, as it determines necessary to carry out its duties.” Translation: Management has been so successful at bullying the auditors into submission that you can’t take anybody’s word for anything anymore. As a result, says investment banker William E. S. Browning of Cronus Partners in South Norwalk, Connecticut, shrewd board members will demand, “Get me a good Rottweiler!”
Boards have always been able to hire their own advisers, of course. During the era of management buyouts, directors routinely formed special board committees and engaged their own investment bankers and law firms. What’s different now, says University of Chicago accounting professor Roman L. Weil, a director of mutual funds affiliated with New York Life Insurance Co. and the chairman of the funds’ audit committee, is that “I used to have to go to management and say, ‘Can I?’ Now I don’t ask. I just present them with the bill. I hire and they pay.”
Hiring independent experts is likely to spread to the board’s compensation committee too, particularly if the Securities and Exchange Commission adopts changes proposed by the New York Stock Exchange. The exchange argues, “If a compensation consultant is to assist in the evaluation of director, CEO, or senior-executive compensation, the compensation committee charter should give that committee sole authority to retain and terminate the consulting firm, including sole authority to approve the firm’s fees and other retention terms.”
Additional board-level issues, including compliance, risk management, and merger transactions, are also likely to provide a growing need for outside consultants. Says David M. Schneider, chairman and CEO of Nextera, the Cambridge, Massachusetts-based parent of Lexecon, an economic consulting firm: “This market for rendering expert independent advice will increase, because the level of activism around these decisions will increase. Few directors will say ‘I can do it myself’ on a big bet-the-company decision.”
All the recent scandals that have rolled like thunder over the corporate prairie have raised the ante on due diligence. The “business judgment” rule used to protect directors who relied on information from a company’s legal counsel or accountants. The board might reach the wrong conclusions, but as long as its members believed the information to be accurate, they had exercised their duty of care appropriately and would not be held liable for their blunders. That safety net may no longer suffice. “Boards ought to worry about relying solely on the business-judgment rule, because the requirements for being well informed have gone way up,” says Bettina Whyte, a principal at turnaround specialist AlixPartners LLC in New York City and a director of Washington Group International, a construction company based in Boise, Idaho.
Katharine Martin, a partner at the Silicon Valley law firm Wilson Sonsini Goodrich & Rosati, notes that directors may need outside advisers when they want to be sure that they have dotted all the i’s on their duty of care. Those situations, she says, “are when the impartiality of the person advising on a business matter is at issue.”
The Sarbanes-Oxley Act is giving a legislative mandate to some practices that were already widespread, such as requiring that members of the audit committee be outside directors. The new law also directs the SEC to demand that a public company disclose whether or not at least one member of the committee is a financial expert. If there is no expert on the committee, the company must explain why.
It’s up to the SEC to figure out what constitutes a financial expert, but there don’t seem to be a lot of them currently serving on boards. According to the Spencer Stuart Board Index, a report on board composition issued annually by the recruiting firm, active or retired CFOs accounted for only 3% of audit committee directors on the boards of S&P 500 companies in 2002. Active or retired accountants made up a meager 2%. And it’s not as if the rest of the audit committee is able to get by. When McKinsey & Co. consultants Robert Felton and Mark Watson surveyed 200 directors who sit on 500 boards across a range of industries and company sizes, they concluded that more than a third (36%) do not understand the major risks facing their companies.
In theory, the board as a whole was supposed to have enough expertise in areas that were essential to the company to guarantee effective oversight. But now directors are responsible for knowing much more about what goes on—even as it’s gotten tougher to do their day jobs. Small wonder that according to Julie Daum, who runs Spencer Stuart’s board practice, 75% of the sitting CEOs she tries to recruit for director slots turn her down.
Not that having experts on the board necessarily guarantees much. Perched right there on Enron’s audit committee was Robert Jaedicke, an accounting professor at Stanford University and a former dean of its business school. Maybe he never did understand the company’s accounting—most people didn’t—but shouldn’t he have recognized the need to get outside help?
Directors who do call in experts can be sure of one thing: Management isn’t going to like it. Too bad, says Thomas Z. Lys, a professor of accounting information and management at Northwestern’s Kellogg School. “Directors are supposed to second-guess management,” he says. “And it’s time for them to start.”
A director should try to avoid confrontation, however. Management will always know more about the internal workings of a company than directors do, and a CEO who thinks that a board member is trying to usurp the business of running the company will probably just stop sharing information. Supervisory relationships do not have to end up in a jailhouse atmosphere, as Lys puts it. You can still be friendly, but don’t forget that your role is oversight.
Once you decide you need expert help, it’s relatively easy to find it. A number of business schools offer director seminars whose classes are taught by specialists in various aspects of governance. Directors should not only attend these classes but, if necessary, also consider hiring the teachers for remedial work geared to the needs of specific boards. For example, the Kellogg School of Management has its Directors’ Week, where for $3,900 you get to stay in a dormitory in Evanston, Illinois, with views of Lake Michigan. Among the many courses is “Accounting and the Audit Function,” which offers “an optional tutorial for participants who would like to refresh their basic accounting knowledge.” The Directors’ Consortium, a three-day curriculum offered jointly by the law school at Stanford and the business schools of the University of Chicago and the University of Pennsylvania, costs $5,350. Room and board is extra.
Directors are by definition well connected, and any four board members could probably craft a list of half a dozen experts on any crucial subject. Moreover, the implosion of Arthur Andersen is likely to result in a few new boutiques of forensic accountants and consultants who’ll be happy to focus their gimlet eyes on your policies for revenue recognition, off-balance-sheet transactions, or the establishment of reserves. Andersen alumni weren’t
all David Duncans, and they will be hell-bent on proving it.
You can apply some simple tests to be sure your advisers are objective, not beholden to management. “Consultants are independent if they are hired by the board and don’t have any transactions or business interests with the company’s executives,” says Benjamin Neuhausen, national director of accounting at BDO Seidman, an accounting firm headquartered in Chicago.
They are also independent if they have no stake in the outcome. This means that they don’t get a success fee if the merger goes through, and if they find holes in your audit practices they are not going to sign off on the next set of financials. Says Jerry Hausman, an economics professor at MIT and a special consultant to Lexecon: “I’m only going to do this one project for the company. If they like me, they may hire me again, but I don’t have any relationship with them.” Nobody’s completely independent, of course, and the consultant may be angling for that next assignment, but at least he owes his allegiance to you rather than to management.
The Sarbanes-Oxley Act has everyone focused on hiring outside experts for the audit committee. But what do committee members actually need? Their first task is to become financially literate. That may mean something as basic as hiring an accounting professor on the quiet for a tutorial in double-entry bookkeeping. On a higher level, “the ongoing responsibility of the audit committee will be to identify the questions to ask the company’s auditors and to get answers that make sense,” says Bill Busch, a former general counsel trained in accounting who now practices law as a partner at Faegre & Benson in Minneapolis. “If the answers seem inconclusive or the audit committee doesn’t have enough expertise to understand them, then the committee should get outside help.”
The expert’s role is not to perform a second audit; rather, it is to reassure the directors where they have specific concerns. For example, are we properly reserved for contingent liabilities? Should we be looking at other ways to classify income? And in the light of WorldCom and Global Crossing, do we have any revenue-recognition issues? Underlying all these questions is one that audit committee members should always be asking: Is there a better, fairer way to present our financial position?
Before you rush out to hire a consultant, however, think about a point frequently made by Roderick M. Hills, formerly SEC chairman and currently chairman of the audit committee at Chiquita Brands International. If your audit committee really takes charge of the audit process the way the Sarbanes-Oxley bill intends, by hiring the auditors, negotiating their fees, and making it clear that they report to you, you may not need any outsiders. “When you confer independence on the auditors, you are no longer in a war with management—the auditor is,” Hills says. “He now works for you, and if he finds something he’ll call you in the middle of the night.”
Most directors have at least an intuitive grasp of compensation practices. And you don’t have to be Dennis Kozlowski to figure out that the gravy train is heading for derailment. As you know, the top brass usually hires a compensation firm to work with human resources and devise a suitable pay scheme for, well, the top brass. The consultant looks at what comparable companies are paying their CEOs and—if he wants to be hired next year—focuses on a group of peers with very generous plans. The board compounds this by telling the consultant that it wants the CEO to fall in the 75th percentile of comparable companies; performance-oriented leaders don’t linger at chintzy outfits, do they? “But everybody can’t be in the 75th percentile. This can only happen in Lake Wobegon!” says Steven Root, managing director of Pearl Meyer & Partners, a compensation consulting firm in New York City. Where all the children are above average, pay increases spiral.
Despite today’s pressure to put a lid on it, “compensation isn’t likely to go down,” says Root. “It may go up more slowly, and maybe we should count that as progress.” Experts can help committees get a little tougher about quid pro quos for executives who want more. Directors should demand that a CEO make a commitment to stay in the job for a decent period, and should tie up the agreement in a contract with teeth. Leave before five years, say, and your options don’t vest. No successor in place by the end of year three? Bye-bye, bonus.
Comp committees can also stop rewarding average performance with above-average pay. James Fox, a partner at the compensation firm Fox Lawson in St. Paul, Minnesota, contends that directors have little understanding of how to use pay to motivate performance. Adds Dan Ryterband, managing director of Frederic W. Cook & Co., a New York City compensation consulting firm: “The reliance on competitive precedent is just an excuse not to use your own judgment.”
All this outside expertise isn’t going to come cheap, of course. But it’s difficult to estimate how much boards will have to spend, because consultants are just gearing up to offer services and directors really don’t have much idea of what they’ll need. For sure, all boards are going to be spending more on the audit itself. “We’re telling our clients that fees will increase on average 20% to 30%,” says Tom Schiro, deputy national managing partner of assurance and advisory services at Deloitte & Touche. And Roman Weil estimates that outside consulting fees will run into the tens of thousands of dollars.
As for other kinds of consultants, who knows? It depends on the complexity of the task, but could be expensive. Nextera’s David Schneider estimates that “the cost of advice on evaluating a business decision for the board would be no more than the cost of an opinion letter from an investment banker in a merger of small or medium-size companies.” That would be around $500,000. Fortunately, you won’t worry about these expenses’ putting your company at a competitive disadvantage—costs will rise for all public companies, at least until the scope of the rulemaking mandated by the Sarbanes-Oxley Act becomes clear.
When you start buttressing your decision-making with experts, do bear in mind that you don’t want to be playing gotcha with management. If the directors always say “Let’s think about this,” and hire consultants for every significant decision that comes before the board, it will be unhealthy. “It suggests there’s a fundamental problem of ‘Does the board trust management?’” says McKinsey consultant Robert Felton. And that, in turn, suggests that you have a more serious problem on your hands than finding outside advice.
