• NIFO - and Your Audit Committee

    01. September 2000

    "Corporate governance" a bland enough topic on its face (corporations, after all, do need to be governed) manages to inspire not just the indifference the words would seem to invite, but genuine acrimony.

    In one corner are pension plans, shareholder activists, and the congenitally disgruntled, all convinced that most boards are boys clubs, snookered by CEO's and lulled or bribed to passivity by perks. In the other, are CEO's, board members and their acolytes convinced not only that they work hard and well, but also, that the American corporation has not become the envy of the world by accident.

    Somewhere to the side are those who cannot find any correlation between "good governance" and the maximization of shareholder value or, for that matter, the maximization of anything else worth maximizing. These same agnostics are hard put to convince themselves that true wisdom mandates specific charters for specific board committees or that anything turns on whether the CEO is or is not also the chairman of the board.

    In the midst of the fray, though clearly on the "reformist" side, is the National Association of Corporate Directors, a not-for-profit organization dedicated -- but not stridently -- to better corporate governance. The NACD has recently adopted governance guidelines for its own board. Since what a physician prescribes for himself is always of interest, we were grateful when Professor Robert Stobaugh, the Chair of the NACD's Governance Committee was kind enough to deliver a copy of the guidelines to us.

    Professor Stobaugh (the Charles E. Wilson Professor of Business Administration Emeritus at the Harvard Business School) is a wise man and his Committee was wisely mindful that brevity is the soul of wit. The guidelines run to less than 11 pages. We pass along for your consumption what we thought were the highlights.

    1. NIFO is the leading principle. NIFO means Noses In, Fingers Out. Outside directors are expected to sniff around but not actually push any buttons.
    2. The only inside director on the board is the CEO. (There are currently nine outside directors.)
    3. The CEO is not the Chairman of the Board; the Chairman must be someone who is not an employee of the NACD.
    4. Outside or "non-employee" directors are defined in conformity with the SEC's rules (effective August 15, 1996) under Section 16 of the Securities Exchange Act of 1934. A director is viewed as independent only if he or she is a non-management director "free of any material business or professional relationship with the corporation or its management and free of any close family relationship with its management."
    5. NACD board members receive no compensation. The only material benefit is that they can attend any meeting or seminar of the NACD with expenses paid by the NACD.
    6. The board has three standing committees: Audit and Finance, Compensation, and Governance and Nominating. The board also has three ad hoc committees: Education, Membership and Publications.
    7. Committee chairmanships rotate every three years. The three standing committees consist of only outside directors.
    8. Procedural guidelines abound with very specific provisions for distribution of agendas and materials. The board itself has only three regularly scheduled meetings annually plus special meetings held as required.
    9. A corporate goal is to have no directors receiving compensation for any services provided to the NACD. For a board member to receive compensation for providing services—for example, teaching in an NACD seminar—the board "must determine that it is the best value available for the NACD, and the board must approve the compensation for such assignments."

    Some of this may sound too pure. Still, the NACD must be doing something right: the board looks pretty distinguished and two of its members, Stobaugh and Ira Millstein, a New York lawyer, are celebrated mavens on corporate governance.

    What especially commends the guidelines is the modesty with which they are presented: "these guidelines may be useful as a starting point for other organizations. . .we emphasize starting point because an important benefit of board guidelines comes from the discussions involved in developing them." (emphasis in original)<

    Modesty is conspicuously absent from "The Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees." The Committee may appropriately have nothing to be modest about. Its members are celebrated; its credentials unimpeachable; and its origins exalted (it was called into being by the chairs of both the New York Stock Exchange and the National Association of Securities Dealers), but what it proposes is no small thing.

    The Report consists of ten different recommendations designed to further what the Report describes as two essentials: "an audit committee with actual practices and overall performance that reflect the professionalism embodied by the full board of which it is a part, and. . .a legal, regulatory, and self-regulatory framework that emphasizes disclosure and transparency and accountability."

    The reader may be forgiven his perplexity as to what those words actually mean and similarly forgiven a disinclination to argue with what sounds like an appeal, however opaque, to virtue. The ten recommendations themselves are easier to fathom.

    The first two purport to strengthen the independence of the audit committee:

    (1) "members of the audit committee shall be considered independent if they have no relationship of the corporation that may interfere with the exercise of their independence from management and the corporation;" and,

    (2) the audit committee shall consist exclusively of independent directors.

    Recommendations 3 through 10 are designed to make audit committees more effective. These recommendations include establishing a minimum size for audit committees (at least three independent directors) and minimal credentials for the committees (all members must be "financially literate" and at least one member must have accounting or related financial management expertise).

    Further, all audit committees must have formal charters and those charters must be disclosed to the shareholders by means of annual reports or proxy statements. The disclosure to shareholders must include a report on whether the audit committee has actually lived up to its charter.

    Living up to the charter includes actively engaging in dialogue with the outside auditors and focusing with the auditors on the quality and not just the acceptability of the company's accounting principles as applied in its financial reporting. Quite apart from the dialogue and the testing of the company's financials on an annual basis, the recommendations contemplate some form of interim financial review prior to the filing of each form 10-Q.

    Right now the recommendations are just that. The Committee is, however, explicit in urging that they be given teeth either by having the NYSE and the NASD embrace them as listing requirements or having the Securities and Exchange Commission embrace them by rule making. How soon these recommendations will become, in effect, the law of the land is unclear, but it appears unlikely that they will be either derailed or attenuated.

    We confess: we too are against financial fraud. In our experience (and we have probably litigated more accounting irregularity cases than any other law firm on the East Coast), the proposed reforms will not do much to rein in true skullduggery, which by its nature is clandestine and not the sort of thing to be captured by more diligent outside directors. Where the recommendations will help is in reining in "earnings management". The hitch is that, until recently, earnings management, including the use of so-called cookie jar reserves, had not been decried as the equivalent of original sin. If managed earnings are in fact the enemy, the audit committees of America need not be conscripted in quite so dramatic a fashion to fight that battle.

    Still there is no arguing that there are plenty of deficient audit committees in the land and, for those deficiencies, no one can pretend that these recommendations aren't potent medicine. Maybe too potent.

    Jeffrey B. Rudman | jeffrey.rudman@wilmerhale.com