The CPA Journal

By George Cox, H. Stephen Grace, Jr., John E. Haupert, Peter Howell, and Ronald H. Wilcomes

The recent spate of corporate disasters almost defies understanding. Some of the largest and most respected companies in the country have imploded or have paid a huge penalty in the markets and the courts. Most of these companies are very actively traded and closely watched by rating agencies and securities analysts. They typically have credit lines with premier lending institutions and relationships with investment-banking firms. All of these various parties with a direct stake in these companies’ health could be expected to help detect and prevent these corporate disasters. Yet, in most instances, disaster struck without much warning to investors, creditors, or employees.

How can this rash of corporate failures be explained? Was this a case of companies seen as too big to fail? Was management given a pass because of the fees paid to the institutions they did business with? Were executives so clever they could hide mistakes and misdeeds from experts that looked at the financials? Or was this just a case of sloppy work by everyone involved? We will probably never know the answers to these questions, but one thing is clear: There must be a way to counteract these real, but well-hidden, threats.

The authors believe the best medicine is a good corporate governance program providing strong oversight and control. The key to good corporate governance is a board and management committed to protecting and enhancing shareholder value and making sure that the key players in the organization are united to carry out this mandate. Who are these key players, and what role should each of them play? They fall into two categories. The first group consists of board members and internal staff; the second group, external partners. Any organization interested in sound corporate governance must look at the proper role and performance of each.

The following are a few questions and issues that should be considered when gauging whether the key players are effective.

Board of Directors, Audit Committee

The board of directors has the senior-most responsibility for the implementation and operation of the corporate governance process. At the apex of the oversight structure is the audit committee of the board. This committee is the ultimate guardian of shareholder value and should ensure that other responsible parties are doing their job. Admittedly, very large and complex organizations are difficult for audit committee members to fully understand and oversee. Nevertheless, this is its role and it must strive to effectively monitor the operations and finances of the organization. One way to do this is to perform an evaluation of the practices and procedures of the committee, using the assistance of corporate governance experts.

Several key items can provide insight into the operations of the audit committee. Is there a manual spelling out policies and procedures? Does the committee keep records of its activities, both regular meetings and special inquiries and studies? How often does the committee meet? Does it have a benchmark for major items that are to be reviewed, and has it been involved in every such action? How often does the committee meet with the CEO and CFO? Is it aware of fees being paid to insiders as part of special financing arrangements or any other transactions? Is the committee apprised of insider stock sales? What is the committee’s degree of involvement in financial statement issues and public pronouncements regarding the financial results and forecasts? Also, to what degree do the board and audit committee set a tone that demands openness and accurate information?

A review of the committee’s relationship with outside parties should also be undertaken. The committee should be appropriately involved in retaining the external auditor firm and should meet periodically with their top staff to hear an appraisal of the company’s strengths and weaknesses. The committee should also meet with investment and commercial bankers, as well as rating agency personnel, about the health of the organization.

Finally, the expertise of the audit committee and any financial interests or dealings that board members have had with the company should be examined. The committee’s independence and technical competence are particularly important. Observers should ask the following questions: Who appointed the directors that sat on the committee? Were they outside directors or part of management? Were they selected for technical competence or for name recognition? The answers should determine whether the audit committee had the independence, power, and knowledge to do its job.

Management

Competent management focused on ethical performance and shareholder value is essential for good corporate governance. Probably the most important way to evaluate management’s performance is to examine its relationship with the board. There should be a relationship of trust built on open communication and the board’s understanding of the business and the management team. Does the board support management and set broad goals and policies while avoiding micro-management? Is management responsive to the board, and do they discuss major new policy initiatives with it? Management has a clear responsibility to work for the benefit of shareholders and not for themselves. Management should make the board and others aware of any compensation received through unusual financing or operating arrangements and any trading in company stock.

The technical competence of the executive staff should also be evaluated. If esoteric financing vehicles are used, independent advisors should be consulted when in-house expertise is not available. Management should have a well-thought-out business development and operating strategy. A good organization should have a risk profile that is prepared, along with plans or hedging techniques used to minimize potential risks.

Internal Audit

The internal audit team in a large company is often overlooked and underutilized. The internal audit team should be independent and have access to and the support of the audit committee and the CEO. Without the ability to bring matters to the attention of senior management and the audit committee, when necessary, internal audit cannot really function effectively. The same is true if the staff is not technically competent or staffed and organized, or if it is considered to be nothing more than financial statement reviewers looking over the accountants’ shoulders.

Legal Department

The company’s legal staff, another lynchpin of the corporate governance structure, must be fully qualified and independent. Who does the general counsel report to? Who do the company’s attorneys see as their client? A properly functioning legal department should have the access and clout to bring questionable matters to the attention of the appropriate parties (be it the CEO, management, or the board) without fear of retribution. In addition, the legal opinions it issues should be reviewed carefully along with the opinions of outside counsel, where necessary.

Outside Partners

Public accountants. There can be no doubt that effective public accountants ensure a sound corporate governance structure and play a most important role in assisting in the audit committee’s oversight role. No one else has the same potential access to the financial and operating data of the corporation and its staff at all levels. It is important to review how the public accountants work with the board and audit committee. Do they have regular discussions of known problem areas? Do the parties discuss difficult reporting issues? The scope and frequency of periodic reviews as well as the annual audit should be examined.

In the current environment, the company and the public accountants should consider a policy of auditor rotation. Another concern should be whether the amount of nonaudit fees raises concerns about auditor independence. Finally, the quality of staff assigned to the account should be looked at. The skills and experience of the supervisor and the staff on the account should be appropriate for the work required.

Major creditors. Although not considered part of a corporation’s governance and control system, the role of major creditors is worth examining. Are bank loans and credit lines competitive, meeting ordinary and customary market terms? It is especially important to determine whether fees and rates are competitive. Existing relationships between major lenders and senior management and board members should be examined. The content of information provided to rating agencies should be reviewed for consistency with corporate reporting policy. The goal should be transparency. Is it possible that creditors and analysts are not doing their homework because their clients are too big to fail or too important to annoy?

Underwriters. The relationship between underwriters and a company’s staff should be carefully explored. How are deals brought to the company? What is the internal approval process? What is the basis for fees? The underwriters should perform due diligence and prepare disclosure documents. Unusual financing arrangements should be discussed with the board. If any employee or board member has a financial interest in a deal, further investigation may be warranted.

An Urgent Prescription

Strong oversight and control are the best prescription for company health. The review of a company’s corporate governance program is not optional; it must be undertaken now. The survival of an organization may be in jeopardy if nothing is done.

H. Stephen Grace, Jr., PhD, is president, and George Cox, John E. Haupert, Peter Howell, and Ronald H. Wilcomes are members of the board of advisors of Grace & Co. Consultancy, Inc. Cox, a consultant on construction and real estate, was managing general partner of Park Central, Ltd. Haupert, a consultant on corporate organizing and financing, was treasurer of the Port Authority of New York and New Jersey prior to retirement. Howell, a consultant on banking, bankruptcy, and reorganization, is the retired director of credit risk management for Deutsche Bank. Wilcomes, a consultant on finance and investments, was vice president and investment counsel of Metropolitan Life Insurance Company before retirement.