Improvements in Board Oversight
Critics of first SOX and more recently of Dodd-Frank contend that rather than changing corporate behavior, the results have been higher compliance costs passed on to investors in the form of lower returns and a spur to some companies to be listed on exchanges overseas to avoid registering with the SEC. Furthermore, some contend that the slow pace of the regulatory agencies to implement laws has contributed to uncertainty in an already economically uncertain market.
According to the law firm Davis Polk’s Dodd-Frank “tracker,” as of July 18, a total of 221 Dodd-Frank rule-making requirement deadlines had passed. This is 78.9 percent of the 280 rule-making requirements with specified deadlines, but only 55.5 percent of the 398 total rule-making requirements, leaving a significant chunk of the future uncharted.
The greatest single change, however, may be the influence of the role of the shareholder. As an executive vice president and longtime legal counsel to ISS, Patrick McGurn has seen governance changes developing for the better part of three decades. While there were significant changes related to accounting, more important are the changes that have empowered shareholders. The embrace of both majority voting and annual board elections, while not direct outgrowths of SOX—many boards had adopted these measures prior to any talk of governance reform in Congress— were accelerated.
The velocity of shareholder activity has increased significantly. There are a greater number of no-vote campaigns against directors, as well as challenges to board policies in the form of shareholder resolutions. In addition, the advent of say on pay—this past proxy season was the second full year since the SEC passed rules requiring say-on-pay votes and say on frequency of say-of-pay votes—instills in directors greater accountability to shareholders. “I think there is a much greater feeling among directors that they’re elected and that they represent the owners of the company,” McGurn says. “Twenty years ago, they owed their position in the boardroom to the CEO.”
What the accounting scandals also surfaced was a need for the board to keep up with the growing complexities of business. Traditionally, CEOs could fill this gap, as they understood those complexities. (Indeed, CEOs join CFOs and accountants as the kinds of professionals that can be considered qualified audit committee financial experts under SOX rules.) But the pool of available candidates was shrinking as sitting CEOs became less willing to serve on outside boards; some companies allow CEOs to sit on only one outside board.
Thomas Neff of Spencer Stuart says companies quickly sought to beef up their financial literacy by recruiting new board members with financial expertise, such as CFOs and retired audit partners.
Coming to terms with the compliance issues increased demands on directors—starting with the need to be more independent, sounding a final requiem on the clichéd, long-waning “old” way of recruiting board members—the CEO’s lawyer, banker and favorite golfing buddy. “There’s been a subtle weeding out of weak directors, and every seat on the board is critical and every director needs to have relevant background and broad business perspective. I think it’s a good thing,” Neff says, and then adds: “But there is an unintended consequence of turnover due to mandatory retirements. However, you don’t want to lose talented directors.”
Arthur Martinez, a highly regarded veteran director who has served on numerous public company boards and is the former chairman and CEO of Sears Roebuck & Co., points to another dynamic in the post-Enron era. Directors have taken charge of the boardroom, transforming once-highly scripted, presentation-oriented meetings into more discussion-oriented environments, he says.
Neff also sees a new generation of CEOs that recognize that they will be held accountable by their boards. Today’s chief executives also are confronted with new risks around their compensation. Under Dodd-Frank, the SEC is considering new clawback rules that are significantly stricter than those under SOX. The proposed rules would allow clawbacks with no regard for misconduct, extend the lookback period from 12 months to three years and expand the scope to include not just the compensation of the CEO and CFO but all current and former executive officers.
“The legitimization of clawbacks is very satisfying for some investors who are tired of seeing executives walk away from a crisis undiminished,” Martinez says. “It is gratifying and satisfying to see some end to the unjust enrichment of the principals.”
On Crisis and Human Nature
The need for qualified directors has never been greater. Good directors are always needed, whether there is a crisis brewing or not.
No one knows this better than Larry Thompson, who was deputy attorney general under President George W. Bush from 2001 to 2003. In 2002, Thompson was named to head up the Corporate Fraud Task Force that pursued criminal charges against officers and directors at corporations including Enron, HealthSouth, WorldCom, Tyco, Qwest Communications, Adelphia Communications, ImClone and Dynegy.
From his viewpoint, over the past 40 years there have been three distinctly different financial crises, from the savings and loan debacle of the early 1980s, to the accounting frauds during the early 2000s, and, most recently, the financial crisis of 2008 that saw the near or outright collapse of such once-respected Wall Street giants as Lehman Bros., Bear Stearns and Washington Mutual. The legislative and regulatory response to each tends to react to symptoms of past crises after the fact and fails to prevent new ones from occurring.
Indeed, what each of these crises has in common is that few people actually saw them coming. “Crises tend to be unpredictable,” says Thompson, who notes that many spring from human foibles. “And no amount of regulation—either mandated or selfimposed— can fix weaknesses in human nature. You just can’t legislate morality.”
Even so, Thompson believes that SOX made clear that “directors represent shareholders with a clear focus on independence and the fact that they are not there to feather their own nests or help their friend the CEO. Second, and equally important, SOX made clear that lawyers and other professional services providers represent the company and not management.” That was a fundamental issue in the Enron debacle. Outside auditors and lawyers working on behalf of Enron either didn’t disclose to or intentionally withheld information from the board that could have shed light on some of the double dealing.
Thompson, who in June returned to PepsiCo as executive vice president of government affairs, general counsel and corporate secretary, says it is now considered a best practice for the board to meet with corporate counsel in executive session. As a result of this new dynamic for GCs in particular, Thompson says he explains a key success factor to his colleagues—and the message is not meant to be flippant. “You have to be willing to be fired. That is the first rule of honest counsel,” he maintains. “If you are in any way afraid of being fired, for economic reasons or whatever, your ability to give unwelcome advice is compromised.”
Directors can work to ensure that the tone at the top is trickling through the middle and all the way down to the lowest levels of the corporation. Berardino and others suggest that directors can help set that tone and monitor it. “Management is going to tell me what they want me to know and what I want to hear,” he says. “My question is, ‘What are they not telling me?’ Your real job as a director is to understand the culture and understand where it can fall down. We all make mistakes, and what you do is important, but how you do it is also important.”
While many fear the effects of too much regulation, the enforcement of rules can provide support to the directors’ oversight role. Speaking as both an advisor and a director, Berardino says he welcomes “a tough cop. If I stand up to a manager, then I want to know they are there to back me up. Managers now know that they can’t play Mom off of Dad.” Still, he admits, “It’s hard to regulate good behavior.”
W. Neil Eggleston, who provided counsel to the Enron directors, says good boards today relate to management with healthy skepticism, and more routinely make visits below the C-suite to develop a better sense of what’s going on or to affirm information being received from management.
While SOX gave the audit committee the right to hire outside advisors without prior approval by management, Eggleston sees an equally important development: the requirement that the CEO and CFO certify the accuracy and truth of financial statements by signing their names to them under penalty of prosecution. Most companies he deals with today have taken those certifications to a different level by instituting “sub-certification” processes. This assures management that their subordinates have performed their internal control duties. A report to the audit committee of what issues or questions were revealed during the sub-certification process—and at large companies sub-certifications may number in the hundreds—and how they are dealt by management can be quite effective.