The Risky Business of Audit Committees
from
Summer 2001
by Lisa Fickenscher
No
wonder it’s been tough lately to find directors who’ll serve on your
audit committee, especially at smaller companies. New regulations have
raised the profile—and account-ability—of audit committee members.
Outside directors could be at greater risk under the new rules, which
went into effect June 14.
As now required by the Securities and Exchange Commission, the New York Stock Exchange, the American Stock Exchange, and Nasdaq, audit committees must include at least three outside directors who are “financially literate.” Two are expected to understand the company’s financial reports, including the balance sheet and income and cash-flow statements. The third, the so-called expert, must meet more stringent requirements and have accounting or financial management experience. In addition, as of a year ago audit committees were required to draft a charter, to be included with the company’s proxy statement, that specifies the committee’s responsibilities. The charters were published for the first time this past proxy season.
The SEC and the exchanges say these rules are simply meant to formalize what most large companies and good audit committees were already doing. Nevertheless, filling audit committee slots is proving tougher, and nowhere more so than at smaller companies that often have relied on friends or relatives of the CEO to serve as directors. “On the financial competency issue, there is no doubt that it is a scramble for the smaller companies,” says Roger Raber, director of the National Association of Corporate Directors (NACD), a nonprofit organization in Washington, D.C. that provides education and research on corporate governance issues.
Of additional concern for smaller companies, most fraud occurs at outfits with revenues of less than $50 million, according to the Committee of Sponsoring Organizations of the Treadway Commission, an alliance of major accounting firms and trade organizations. The group surveyed companies cited by the SEC for violating antifraud statutes and found that such companies had “phenomenally weak audit committees,” says Dana R. Hermanson, co-author of the report and director of research at the Corporate Governance Center at Georgia’s Kennesaw State University. More than 50% of the audit committees in the study met only once a year, and only about a third of the members had accounting or financial experience. “There is a strong sense among small companies that audit committee members’ legal liability is on the rise,” says Hermanson.
Anxiety over the new audit committee requirements isn’t limited to directors of small companies, however. “It has always been difficult to recruit directors for audit committees, regardless of the size of the company,” says Dennis C. Carey, vice chairman of Spencer Stuart, an executive recruitment firm that specializes in finding board members. “And the new requirements have exacerbated the problem.”
While the current evidence is largely anecdotal, corporate governance experts have heard an increasing number of directors say that the risks outweigh the benefits of having a seat on the audit committee, and directors are declining to serve. In fact, at least one audit committee member, Kathryne Harrigan, a strategic management professor at Columbia Business School in New York City, quit a board before the new rules even went into effect, partly because of the difficulty in recruiting three financially literate, independent directors. She declined to identify the company.
Whatever the challenge, directors obviously cannot choose to ignore the new rules. At worst, a company that does not have the appropriate directors on its audit committee faces being booted off the exchange on which it is traded. Such companies and their directors are also exposed to a greater risk of being sued.
Class-action lawsuits alleging accounting fraud are already on the rise: 53% of all securities cases filed between 1996 and October 2000 alleged accounting fraud, up from 38% from 1991 through 1995. Similarly, lawsuits involving earnings restatements accounted for 19% of all securities cases between 1996 and October 2000 versus 9% from 1991 through 1995, according to National Economic Research Associates, an economic consulting firm in White Plains, New York. Typically, stock market volatility creates more class-action securities lawsuits, according to NERA.
While all board members run the risk of being named in such suits, the danger is greatest for audit committee members, especially under the new rules. Consequently, directors are stepping up to the plate with a new wariness. According to a survey of 205 audit committee members conducted last year by Corporate Board Member and KPMG’s Audit Committee Institute, 50% of the respondents believe their personal liability has increased as a result of the rules. The percentage jumps to 80% of respondents at companies with sales of less than $500 million.
Their anxiety is warranted. Charles M. Elson, director of the Center for Corporate Governance at the University of Delaware, says a big concern is the financial know-how directors are expected to bring to the table. Elson and other experts argue that class-action attorneys will find a way to show that a director’s financial savvy was not up to snuff and, therefore, contributed to situations resulting in shareholder harm. “Financial literacy is a term without a real definition, which makes it a petri dish for litigation,” says Elson.
The “expert” on the committee, however, is wearing the real bull’s-eye. “If there is an issue, someone has to raise their hand when shareholders and lawyers ask, ‘Who was the expert?’” says Scott A. Reed, senior manager of KPMG’s Audit Committee Institute in Montvale, New Jersey. Companies are not required to identify the director who is their expert in the papers they must file with the exchanges attesting to their compliance. Even so, “everyone is ducking the expert issue,” says Nancy Wilgenbush, president of Marylhurst University of Portland, Oregon, and a member of the audit committee at Cascade Corp., a Portland manufacturer of parts for lift trucks. “There seems to be a reluctance to proclaim oneself as the first among equals in regard to expertise, assuming that if there is a problem, that expert would be held to a higher standard of diligence.” So who is the first among equals on Cascade’s audit committee? Wilgenbush says while at least one director meets the expertise requirements “with flying colors, the matter has never been discussed.”
Where does this leave companies and their D&O insurance coverage? The escalation in the number of lawsuits already has driven premiums up, and the new SEC and exchange rules provide another reason for insurers to raise rates and even drop companies. New York-based National Union Fire Insurance Company of Pittsburgh is evaluating the audit committees it covers, meeting or speaking regularly with members to determine whether they are following the spirit of the rules. As of late March, about 5% of National Union’s clients, mostly smaller companies, were not in compliance and, consequently, at risk of being dropped. “We don’t like [dealing with] the companies that wait to the last minute,” says Paul J. Schiavone, the former chief underwriting officer and vice president, who recently took another job at AIG, the parent company. “If we think the audit committee is just OK, you may see a 5% to 10% increase in premiums.” On the other hand, if National Union is impressed with an audit committee, it may lower its rates.
All of this hand-wringing is unnecessary if an audit committee simply does its job, says Ira M. Millstein, co-chair of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, on whose report the new rules are based. “No director has ever been held guilty if they have done their job with integrity and diligence,” says Millstein. “We didn’t invent anything here. We modeled the process on what good boards were already doing.”
The financial literacy standard, Millstein and others argue, shouldn’t be a serious hurdle for a director serving on an audit committee. After all, a director who doesn’t understand basic accounting procedures shouldn’t be on an audit committee anyway. Harvey J. Goldschmid, a professor at Columbia Law School who was general counsel of the SEC when the rules were adopted, says directors should feel protected rather than threatened. “Fundamentally, the new rules will mean that audit committees will be more active, and this activity is highly protective under both state duty-of-care laws and federal securities laws.”
The charter in which a company sets out the responsibilities of audit committee members is another area of concern for some directors. “The criticism of the charter requirement is that it ties the audit committee’s hands to act flexibly by saying you must do the following 37 things,” says Helen Scott, a professor of law at New York University Law School and co-chair of a council that develops policy recommendations for the Nasdaq board. “If the committee does 36 of the 37, it is exposed to liability.”
One way for directors to protect themselves is to make sure the charter is a reasonable document. “Don’t over promise or merely write things down in a charter because they look good,” says Larry W. McCurdy, who serves on the audit committees of Lear Corp., American Axle & Manufacturing, and Mohawk Industries.
In fact, some believe that a charter, like audit committee requirements, actually protects board members, serving as a contract between the board, the audit committee, and the shareholders. Says Edward Labaton, a partner of Goodkind Labaton Rudoff & Sucharow of New York City, a law firm that specializes in class-action securities cases: “A charter provides a guideline for what is expected of directors.”
Wise audit committee members will still bone up on accounting issues. Several educational options are available. The NACD offers a basic course that includes instructions on how to read financial statements. Next year, the Center for Corporate Governance at the University of Delaware will be offering seminars tailored to audit committee members.
Directors can also cover their backs if they make it clear to the company’s management that they are paying close attention to details. Kathryne Harrigan, who quit one board because of her concerns, serves on the audit committee of Cambrex Corp., a chemicals manufacturer in East Rutherford, New Jersey. She tunes in to the company’s conference calls with analysts and others and watches company webcasts. “I’m listening primarily just to be sure that nothing is untoward,” she says. “If I don’t like the way the conversation is going, I might make a comment later. When a board member takes the time to devote attention to a matter, that sends a message to the company.”
It also sends a signal to any lawyers fishing for class-action action.
