Accountants Serving as Corporate Directors
By Susan S. Jarvis and Wig De Moville
In the wake of the Sarbanes-Oxley Act of 2002, the demand for accountants to serve as corporate directors is likely to increase, and the associated liability of corporate directors with “special expertise” may increase as a matter of law. Under the Sarbanes-Oxley Act, corporate directors will have to exhibit more accounting expertise, and may be subject to greater legal exposure. An accountant serving as a director on an audit committee may find himself facing a catch-22: He must be an expert to be the financial expert of the audit committee; however, should malfeasance take place without his having detected it, his expertise and diligence will be questioned. Conversely, should he discover malfeasance that is sufficiently serious to bring down the company, he will not be hailed as a hero.
The Sarbanes-Oxley Act
Title III, “Corporate Responsibility,” and Title IV, “Enhanced Financial Disclosures,” of the Sarbanes-Oxley Act have the most bearing on the legal responsibility and liability of the accountant/director. “Accountant/director” is defined to mean a member of the board of directors who, through education and experience, has an understanding of GAAP and certain specific experience regarding its application.
The act holds that the audit committee of a company issuing financial statements under section 3 of the Securities Exchange Act of 1934 is responsible for the appointment, compensation, and oversight of the auditor. While audit committees have traditionally reported to the board of directors and often have been composed of board members, the Sarbanes-Oxley Act gives this tradition the force of law.
If a board of directors does not have a separate audit committee, then the entire board is considered to be the audit committee. Each member of the audit committee must be independent of the company and its officers. Independence, for this purpose, means that “a member of an audit committee of an issuer may not, other than in his or her capacity as a member of the audit committee, the board of directors, or any other board committee (i) accept any consulting, advisory, or other compensatory fee from the issuer; or (ii) be an affiliated person of the issuer or any subsidiary thereof.”
One of the responsibilities of the audit committee, according to the act, is to establish procedures for “the receipt, retention, and treatment of complaints received by the issuer regarding accounting, internal accounting controls, or auditing matters; and the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters” [III 301 (4) (A) (B)]. The act also provides that the audit committee “shall have the authority to engage independent counsel and other advisors, as it determines necessary” [III 301(5)], as well as determine appropriate funding for the auditors and any other advisors.
A company must disclose whether at least one member of the audit committee is a financial expert. The SEC has yet to strictly define “financial expert”; however, the Sarbanes-Oxley Act requires that it consider the following when defining the term: “whether a person has, through education and experience as a public accountant or auditor or a principal financial officer, comptroller, or principal accounting officer of an issuer, or from a position involving the performance of similar functions, an understanding of generally accepted accounting principles and financial statements” and “experience in the preparation or auditing of financial statements of generally comparable issuers; and the application of such principles in connection with the accounting for estimates, accruals, and reserves;” as well as “an understanding of audit committee functions” [IV 407 (b)].
Under the act, directors, officers, and principal stockholders are required to make certain disclosures. A director must disclose any holdings of the issuer’s securities and any changes in the amount of securities held.
Demand for Outside Directors
It is likely, given the requirements of the Sarbanes-Oxley Act and the current market, that the demand for outside directors will significantly increase and finding good candidates will be increasingly difficult.
Concern over personal liability will be a major factor in finding suitable candidates. In 1999, shareholders and bondholders filed 109 class action securities fraud lawsuits; in 2001, this number rose to 485. According to USA Today, liability insurance premiums have risen as much as 700% in less than a year for some companies.
In order to encourage CPAs to serve on corporate audit committees, the AICPA plans to open a Center for Audit Committee Effectiveness. In addition, the AICPA provides an Audit Committee Matching System to “match” CPAs with companies looking for qualified board members (acms.aicpa.org).
The Business Judgment Rule
Based on the potential demand for outside directors with financial expertise, an increasing number of accountants may be invited to serve as corporate directors. According to Rule 101 of the Uniform Accounting Act, an accountant’s independence is impaired if one serves as a corporate director during the time period covered by the financial papers prepared by the accountant’s firm.
A major concern of any corporate director is potential personal liability if the corporate shareholders file a lawsuit. One defense strategy is based on the common law’s business judgment rule, which may offer protection from personal liability.
In order to encourage capable persons to serve as directors and to discourage the courts from second-guessing corporate decision making, the business judgment rule protects directors in two ways. According to Robert G. Heim, writing in the March 2001 New York Law Journal: “First, it will prevent directors from being held personally liable for decisions that later turn out to be unprofitable or misguided. Second, it will protect the integrity of decisions made by a corporate board from challenges by shareholders or third parties.”
The rule requires that directors perform their duties with due care and with loyalty. Terrence C. Sebora and Michael J. Rubach have defined due care as requiring that “the board act (1) in an informed manner, (2) in good faith, (3) as an ordinarily prudent person, and (4) in a manner it believes to be [in] the best interest of the firm.” Loyalty requires that the board of directors “(1) avoid conflicts of interest, (2) deal fairly, and (3) act with a rational business purpose” (Journal of Business Ethics, 1998).
In June 2003, a judge in Delaware determined that a shareholders’ revised complaint, first filed against the Walt Disney Company in 1998, could go to trial. The shareholders alleged that board members failed to comply with the business judgment rule in approving an employment contract for the former president of the company that allowed the executive to leave with a severance package of approximately $140 million (In Re The Walt Disney Company Derivative Litigation, Court of Chancery of Delaware, 731 A.2d 342).
Most jurisdictions allow directors to rely upon the opinions of experts. A director with special expertise, however, may not escape liability through relying on third-party advice.
In addition to the business judgment rule recognized by the common law, statutory law may also protect a director from personal liability. The most widely adopted statute is based on the Model Business Corporation Act (MBCA). The MBCA was drafted by the American Bar Association’s Committee on Corporate Law in 1950 to bring some uniformity to corporate law throughout the states. The Revised Model Business Corporation Act (RMBCA) was adopted in 1984. The RMBCA was amended in 1998 with further changes relevant to director liability. A majority of states have adopted a version of the original or revised MBCA.
The 1998 amendments to section 8.30 of the MBCA addressed potential liability for directors. Directors are to be held to the following standards of conduct:
(a) Each member of the board of directors, when discharging the duties of a director, shall act (1) in good faith, and (2) in a manner the director reasonably believes to be in the best interests of the corporation.
(b) The members of the board of directors or a committee of the board, when becoming informed in connection with their decision-making function or devoting attention to their oversight function, shall discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar
(c) In discharging board or committee duties a director who does not have knowledge that makes reliance unwarranted is entitled to rely on information, opinions, reports, or statements, including financial statements and other financial data, prepared or presented by any of the persons specified in subsection (e).
Directors’ reliance on information supplied by others is addressed as follow:
(e) A director is entitled to rely, in accordance with subsection (c) or (d), on:(1) one or more officers or employees of the corporation whom the director reasonably believes to be reliable and competent in the functions performed or in the information, opinions, reports, or statements provided;
(2) legal counsel, public accountants, or other persons retained by the corporation as to matters involving skills or expertise the director reasonably believes are matters (i) within the particular person’s professional or expert competence or (ii) as to which the particular person merits confidence; or
(3) a committee of the board of directors of which the director is not a member if the director reasonably believes the committee merits confidence.
The statutory provisions of the RMBCA must be evaluated against the common law business judgment rule’s applicability to director conduct.
In addition to the responsibility for decision making, a director also has an oversight duty. Section 8.31 of the 1998 amendment addresses this oversight responsibility: “If the challenged conduct involved a sustained failure by the director to devote attention to the oversight function or a specific failure to devote timely attention to a demonstrable need for inquiry when particular facts and circumstances of significant concern materialize, it will be actionable.”
In those states that have adopted the 1998 amendments to the RMBCA, an accountant/director must pay proper attention to oversight functions and conduct an inquiry when facts or circumstances indicate it is necessary.
Principles of Corporate Governance
In addition to the common law business judgment rule and statutory laws, principles of corporate governance may also apply to a director’s duty. These principles include compliance programs recommended by the American Law Institute (ALI).
In 1994, the ALI adopted the Principles of Corporate Governance. These principles provide that directors may be personally liable if the compliance systems are deemed inadequate based on three types of standards. The standards established in section 4.01(c) include the business judgment rule, negligence, and the affirmative duty to act.
To determine if a party is negligent, the plaintiff must prove that the defendant owed a duty to the plaintiff, that the defendant breached that duty, and that the breach was the actual and proximate (foreseeable) cause of the plaintiff’s injuries.
Reducing Personal Liability Risk
Audit committee duties. If an accountant/director serves on a corporation’s audit committee, certain steps may reduce the potential for personal liability related to these duties. Audit committee members have two basic duties: care and loyalty.
According to Olson, Mueller, Tsacoumis, and Goodman, the duty of care requires that audit committee members attend meetings, participate, vote on appropriate matters, and inquire as to potential problems when circumstances indicate. Questions should be based on the director’s own expertise.
The duty of care further requires that the director act in good faith in the manner of an ordinary prudent person in similar circumstances. According to David J. Kaufman in Insights, board members should question management’s judgment and decisions. The accountant/director’s duty of care requires asking questions based on her expertise. Accordingly, directors should refrain from relying completely on experts; meet independently with experts and raise questions; meet separately with management and question decisions; establish and adhere to corporate standards/codes; read all relevant materials; understand the issues; have timetables for reports; devote the necessary time and attention to the board; and remain flexible.
The duty of loyalty requires that the accountant/director be independent of the company. Olson, Mueller, Tsacoumis, and Goodman (“After Enron: Issues for Boards and Audit Committees to Consider,” The Corporate Governance Advisor, May/June 2002) recommend that the audit committee examine any and all relationships between the committee members and the company.
The SEC’s final rules requiring disclosure as it pertains to financial experts on audit committees became effective on March 3, 2003. Regarding the question of whether financial experts will be held to a higher degree of responsibility, the final rule provides a safe harbor which states that experts are not held to greater “duties, obligations, or liabilities.” Despite the safe harbor provision, there is still concern over the possibility of increased liabilities for financial experts. Ultimately, questions of liability will be decided in the courts.
According to Steven Radin in Metropolitan Corporate Counsel, lawsuits against outside directors will make the courts consider a number of issues: whether directors lost their exemption from liability (as provided by state statutes) due to lack of good faith; whether a shareholder can bring a derivative action on behalf of the corporation due to the futility of demanding action by the board or the board’s wrongful refusal to bring action; and whether a plaintiff can use summary proceedings (such as section 220 of the Delaware General Corporation Law) to seek inspection of corporate books and records.
Section 220 was used by plaintiffs in Saito v. McKesson HOBC, Inc. (2002 Del. Ch. Lexis 139) to obtain certain corporate information. In that case, the court stated, “It is well settled that the investigation into corporate waste and mismanagement is a proper purpose for a books and records inspection under section 220.” It is possible that statutory authority with regard to books and records may be used more extensively in future shareholder lawsuits.
Duty relevant to creditors. As a general rule, a director’s responsibilities are focused on duties owed to shareholders. The director of an insolvent corporation, however, also has a duty to creditors.
James Seely, in the February 1, 2002, Houston Business Journal, advised the following steps when directors determine a corporation is insolvent or insolvency is foreseeable:
In addition to the items above, the audit committee should exercise significant care to diligently examine transactions in the weeks preceding quarterly earnings announcements. This examination may be critical if the firm barely meets or exceeds the market’s expectations. Because stock prices often fall with the failure to meet these expectations, management may be tempted to fudge the numbers. The committee should also be alert to the possibility that if management sees that the earnings will not meet market expectations, it will try to take a “big bath” by recognizing losses in this period.
Understanding the Risks
Accountants that agree to serve as directors can reduce their risks of personal liability by understanding the areas of potential liability and seeking legal advice whenever a hazardous situation arises.
Accountants serving as directors may also find the following suggestions useful:
Dan L. Goldwasser, Esq.
Vedder, Price, Kaufman & Kammholz
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
Visit the new cpajournal.com.