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Sunday, September 11, 2011

Corporate Governance Gets Serious

Corporate Governance Gets Serious: "Corporate Governance Gets Serious"

Boards are under harsh scrutiny by regulators and investors looking for wrongdoing. CFOs are playing a critical role in implementing sound governance policies to guard against such concerns, both within their organization and when serving on external boards.

Paychex vice president and CFO John Morphy hasn't altered his approach to corporate governance much in the past three years. In December 1998, Morphy fought to make sure that the Roches-ter, N.Y.-based payroll processing and HR outsourcing firm filed its 10-Q on the same day it conducted its quarterly conference call and issued the accompanying earnings press release. "That was before Reg FD [Regulation Fair Disclosure]," he says, "but I thought we needed to do everything possible to ensure that all of our shareholders received all of our information at the same time."

Two years later, Morphy again demonstrated his commitment to effective reporting when he walked away from an outside board position he held with an Internet company. "There were a few things I asked them to do with regard to governance issues," he recalls, "and it became apparent that they weren't going to do them, so I resigned."

Morphy's decision to leave that company's board underscores the widespread shortcomings of corporate boards. Following Enron and the dismantling of Andersen, investors are questioning the quality of corporate performance reporting, and personal liability is becoming a critical concern for board members.

This atmosphere requires CFOs to rethink governance on two fronts. They are increasingly being asked to provide their financial expertise as outside directors, while at the same time they need to strengthen oversight in their own house. For both roles, they must keep a finger on the pulse of the governance debate.

Too Many Options

Remedies for financial reporting problems are cropping up everywhere this spring. Leading columnists, consultancies and financial services firms have published an array of opinions offering guidance. Holman W. Jenkins Jr., a member of the editorial board of The Wall Street Journal, floated the suggestion that CFOs "unhitch their job from the stock incentives that drive the chief executives."

The Corporate Governance Center (CGC), a group of business professors, offered the same recommendation for audit committee members in late March. "If you have a lot of stock in the company on whose audit committee you sit -- particularly if that stock is material to your personal wealth -- you can become more concerned with short-term stock price maximization than you are with the financial reporting transparency and financial reporting accuracy," says Joseph Carcello, a fellow at the CGC and a professor of accounting at the University of Tennessee in Knoxville. "That concern can lead you to overlook questionable actions by management."

This doesn't mean the CGC wants to stiff audit committee members; on the contrary, the group suggests that boards consider giving them a raise. "We're suggesting that there may need to be a different level of compensation for the directors who sit on the audit committee," Carcello says. "Audit committee members just have more work to do than other directors. The reality is that the audit committee members are already primary targets if there is a financial reporting problem. Their level of compensation should be commensurate with doing more work and taking on additional risk."

Another CGC recommendation that is likely to raise corporate eyebrows is the idea that companies should separate the CEO and chairman of the board titles. For organizations not willing to divide these duties, the CGC recommends naming a "lead outside director" who can run meetings restricted to outside directors.

Not a Beautiful Mind-set

Describing much of the FASB's accounting guidance as "proscriptive," Carcello says complex rules often contribute to a compliance mind-set. "Corporate officers will say to auditors -- and this is a direct quote I've heard from audit partners -- 'Show me where it says I can't do this.' That's a very legalistic view of accounting," he says. "Transactions are structured to meet the letter, but often not the spirit, of accounting rules. And you end up with accounting treatments that may be legally acceptable but that are not conveying to the investor, creditor and other users the economic reality that the corporation is facing. That's a big problem."

Some CFOs certainly push FASB rules to the limit. But others, such as Morphy, evaluate the reasons and conditions that underlie regulations, then take decisive action based on FASB logic, rather than waiting for a rule on a specific issue. For example, in May 1997, Paychex became the first payroll company to include funds held for clients on its balance sheet. "I believed it was the right thing to do," Morphy says. "We raised the issue and looked at the disclosure. And then we determined that the money should go on the balance sheet, even though the industry practice said otherwise."

Morphy called a special meeting of the Paychex audit committee, and members examined how the balance sheet change would affect the income statement (it would not) and the company's disclosure process. "Consensus was reached pretty quickly," Morphy recalls. "But the audit committee members were thorough. They wanted to make sure we had title to the money. I received some challenges based on the fact that this was not industry practice. But I explained how our disclosure would be improved."

The CGC would like to see all companies' boards and management teams embrace Morphy's approach to governance. "The mind-set needs to be: If I'm looking at these financial statements, do they convey to me what I need to know to evaluate the risk and return that an investment in this corporation would probably entail?" Carcello notes. "If the answer is no, there is probably something wrong with the financial statements."

Do They Read the 10-K?

CFOs also must ensure that everyone involved in their company's governance processes is knowledgeable and inform-ed. Within public companies, responsibility for detecting and correcting financial reporting shortcomings rests with the organization's senior management and board of directors. Finance executives can improve the quality of this oversight by improving the board's understanding of financial reporting processes, SEC guidelines and the markets in which the company operates.

"It really boils down to whether your directors are fundamentally qualified and whether they're engaged in what they're doing," says Reginald Babcock, president of Corporate Governance Services, a governance advisory firm in Glastonbury, Conn. "And there's really no way to know that unless you're in that boardroom. A friend of mine is a director at a couple of companies. He said, 'I read the 10-K; I'm probably the only director who truly reads the 10-K.' That's a great way to judge whether somebody is doing their job as a director."

Babcock suggests that CFOs put themselves in their directors' shoes to determine how they can encourage the directors to be as involved in reporting as they need to be. "Spoon-feed them the 10-K, and get it to them on time," he says. "Make sure their input is listened to. I think there are a lot of directors on a lot of boards who want to do the right thing but don't feel their voices are heard or that their points are heeded. If the CEO's not doing it, one of the only other positions that really has the standing to force better dynamics between management and the board is the CFO."

Lowell Robinson, who was senior executive vice president and CFO of HotJobs .com until Yahoo! Inc. acquired the business earlier this year, has also held senior finance positions with Kraft/General Foods and Citigroup. "I found that the boards I worked with generally didn't need that much education on the business," he notes. "What they did want from me was an understanding of the numbers, as well as the metrics and levers driving the numbers."

The Learning Curve

The financial and business expertise among board members varies, of course. CFOs might be better prepared to educate their directors if they understand what their board and its nominating committee look for in new recruits.

Charles King, managing director of the global board services practice at Korn/Ferry International, a provider of executive human capital solutions in New York City, says director searches differ from executive searches in two ways. First, the commitment is much different. Rather than asking candidates to walk away from an employer who has been good to them for 15 years, boards ask candidates to "carve out 150 hours or more every year to contribute their knowledge and expertise to another company," says King.

The second difference is chemistry, which he says is the "overarching factor" in the recruitment of board members. King describes a situation where a CEO who wants to hire the best CFO for a company could look beyond the fact that the best candidate might not be the best cultural fit for the management team. That isn't possible in the director searches King conducts because, he says, the board is "essentially a team that needs to play well together and that rules largely by consensus."

What drives people to want to serve on boards of directors in this time of heightened regulatory scrutiny? Despite the compensation, which can range from $30,000 to $200,000 a year or more (depending on stock options), directors should not accept the position for the money, King insists. "If the first question they ask when we call them is 'What's the compensation package for the director?' we know we have the wrong person," he says.

Most board members want to make a contribution because they have an interest in the company's business or industry. "What's critical in the equation is that they have to be able to learn something from that board experience which will enhance them in some fashion," King adds. "The affiliation value is something that means a lot to all of these directors. They enjoy the opportunity to associate with other smart, interesting people."

Don't Know or Don't Care

The best way for CFOs to ensure that smart board members become, or remain, financially astute is through open communication. "I talk to almost all of our board members periodically throughout the quarter," says Morphy. "I talk to those on the audit committee more frequently than that."

Morphy and his audit committee have made some changes in the wake of the Enron debacle. A year ago, the audit committee met twice a year, and the audit committee chair met with Morphy, several of his key accounting staff and representatives of Ernst & Young (Paychex's external auditor) each quarter to review the financial statements prior to the earnings release. Recently, the full audit committee has begun gathering six times annually, as the quarterly review sessions have morphed into formal meetings of the entire committee.

"The best way to have a good audit committee is to have good members," notes Frederick D. Lipman, senior partner, business and corporate department, of Philadelphia law firm Blank Rome Comisky & McCauley LLP and co-author of "Audit Committees" (The Bureau of National Affairs, 2000-2001). He smiles when he says this, but his point -- that CFOs can help build better audit committee members -- is a good one.

He notes that CFOs can keep members up to speed on SEC developments, summarizing speeches by commissioners and staff and highlighting potential changes or actions by the commission. Finance executives can also explain to audit committee members the peculiarities of their company's accounting and how the business meets SEC guidelines. "That's a very complex issue," Lipman adds. "It requires a lot of education and is not something that can be covered in one session. The audit committee changes; directors retire. So it's a constant process, and there are always new issues arising."

To ensure the health of his relationship with the HotJobs audit committee, Robinson met with the committee chair every two months. "We would go over the state of the business so he was up to speed in terms of the overall economic environment in our industry," he notes. "We would also go over the outline and sketches of the formats we planned to use for the information we presented at the audit committee meetings."

Lipman agrees that the CFO and the audit committee should maintain an "ongoing, interactive, collegial" discussion about reporting issues. "If the audit committee members are too often on the receiving end of the discussion, if they're not asking questions and probing issues, then either the audit committee members are embarrassed to admit they don't understand the issue, or they just don't care," he adds. "Either situation is trouble."

Viable Candidates

A growing number of companies are raising the financial IQ of their boards by considering CFOs for outside directorships. Their familiarity with accounting policies, the SEC and -- in recent years -- the high-level business strategy that drives success makes finance executives appealing candidates. "CFOs are being recruited to boards today," says King. "Five years ago they would not have been considered viable candidates."

Thanks to recommendations from the 1999 Blue Ribbon Panel on Audit Committee Effectiveness and to the fact that CEOs have cut back on their outside director activities, "we are hearing clients say that they want strong financial talent for their audit committee and they are fully prepared to recruit a chief financial officer from a major corporation, who, in addition to finance, probably brings other relevant experience," says King. He estimates that 10 to 15 years ago Fortune 1000 CEOs served on an average of four boards. In part because of greater pressure from institutional investors, Fortune 1000 CEOs today sit on an average of less than two outside boards, according to King. That leaves several thousand board seats open -- ample opportunity for CFOs to tone their corporate governance muscles with a change of scenery.

The extent to which new laws will change the corporate governance landscape will become clear in the months ahead. CFOs with firm approaches to strengthening governance -- with or without regulatory guidance -- will have an easier time navigating that terrain than those who are less proactive.

The D&O Dilemma

The average directors and officers (D&O) insurance premium rose more than 24 percent from 2000 to 2001, according to preliminary results from the annual D&O liability survey by Tillinghast-Towers Perrin. The median premium rose 12 percent over the same time frame. These jumps follow an 11 percent increase in the average D&O premium from 1999 to 2000, although the median premium declined 2 percent during that time period. Last year's 12 percent median increase is a "significant number because it represents how broad a portion of the market has been affected," says Mark Larsen, director of the D&O survey and a consultant for Tillinghast-Towers Perrin in Chicago.

While Enron might serve as a convenient scapegoat for rising D&O costs, a string of massive claims is actually to blame. Settlements or judgments for more than a dozen claims have topped $100 million over the past 18 months, according to Jim Swanke, strategic risk financing practice director for Tilling-hast-Towers Perrin in Minneapolis.

Some analysts liken the hard market to the D&O crisis of the mid-1980s, but Swanke points out that the previous hard D&O market was capacity-driven. "There just simply was not enough insurance out in the marketplace," he says. "Today, there's lots of insurance and lots of limits that are available. Capacity in the marketplace is as good today as it has been in the past three or four years, if not better." The differences from previous years are that today underwriters are more selective and that more D&O insurers encourage co-insurance, which requires the insured company to pay a portion of each claim -- say, 20 percent -- after the deductible is met.

Swanke estimates that average D&O premium increases will remain in the 20 percent to 30 percent range for 2002. Further, he expects the crisis to last at least another 18 to 24 months, depending on how many more enormous claims arise. That caveat could lead to worse D&O news for companies, notes Frederick Lipman, senior partner, business and corporate department, of Blank Rome Comisky & McCauley LLP in Philadelphia. "We'll see the SEC start targeting audit committees," he says. "Some of these cases may turn out to be criminal. Most of the time, the audit committees were just not knowledgeable about what was going on."

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