Peter D. Raymond

Large capital projects—with their multi-year timelines, changing requirements, and complex procurement issues—are inherently risky. They require diligent oversight, given the common occurrence of budget overruns and their impact on the company’s financial health.

Lack of board oversight can result in severe consequences. For example, in the power sector, regulators have rejected substantial portions of capital funding requests in situations where they believe management and the board could have exercised better oversight of costs, schedules, and risks.

Corporate boards have the responsibility to oversee a company’s strategy and key risks. Capital projects fall squarely in this realm in light of their significant costs and the business implications of delayed or over-budget projects.

“Large capital projects, by their nature, tend to be long term,” says Craig G. Matthews, a director on the boards of Hess and Natural Fuel Gas. “Factors beyond your control can impact them. For example, look at the financial crisis and the dramatic change in interest rates since then.”

A capital project is rarely derailed by a single problem. Rather, a series of failed steps can jeopardize a project. The primary contributor to project failure is lack of early planning, according to a 2012 PwC survey of some 1,500 respondents in 34 industries in 38 countries.

Deficiencies in early planning generally result from the following:

• Objectives do not align with business needs.
• Managers and project planners oversell what the project can deliver.
• Risks are not fully vetted with key stakeholders.
• Project owners don’t plan appropriately for cost and schedule overruns.

When issues snowball without adequate reporting to the C-suite and board, even companies with experience in capital projects can be caught off-guard. Issues that impede a capital project—despite strong upfront planning—include project complexity, scale, location, and the role of new technology.

The degree of the board’s involvement in a capital project depends on a variety of factors, including the magnitude of the investment, its strategic importance, the proven track record of management to handle complex projects, and the project’s susceptibility to identified risks.

Directors can ask questions of management to evaluate the desired strategic and tactical business objectives (lower production costs or increased outputs) as well as project performance (measured by key performance indicators) against actual progress.

Some of those questions include:

• What key external (business and regulatory environment) and internal (schedule, performance, costs) risks does this project encompass in its multi-year life cycle?
• Do the company’s directors possess the knowledge and experience to ask the right questions and interpret the responses? Does the board need to engage an independent advisor?
• How should the board get more involved? For example, would a site visit facilitate a better understanding of the project’s scale and complexity?
• Does management have the appropriate controls in place to provide timely and accurate updates to the board on the status of the project?
• What warning signs should the board look for when evaluating project reports? Examples might include missed deadlines or repeated requests for a budget increase.
• When and how should the board intercede when a project is facing repeated time and cost overruns?

Capital projects require careful forethought, comprehensive planning, and vigilant monitoring. Responsibility for day-to-day decisions lies with the project management team. The board of directors, however, should ask the right questions of management—questions that ensure project performance meets strategic goals while conforming to the company’s overall tolerance for risk.

Peter D. Raymond is the U.S. leader of PwC’s Capital Projects and Infrastructure business. Reach him at peter.d.raymond@us.pwc.com or 703-918-1580.

What can we make of pay definitions, which have these types of variances in total CEO compensation?

• ConocoPhillips: Was CEO pay $19.4 million or $154.7 million?
• Capital One Financial: Was CEO pay $164,000 or $20.5 million?
• Oracle: Was CEO pay $5.5 million or $96.2 million?

Jack Zwingli

These are clearly some extreme examples, but there are many more like them. Obviously, conclusions on pay-for-performance alignment will vary based on which definition you use.

The number of alternative definitions— and their various permutations—continues to grow. Starting with proxy disclosures required by the Securities and Exchange Commission, notably the Summary Compensation Table (SCT), we can add target pay, grant date value pay, realized pay, realizable pay, and Farient’s performance-adjusted compensation (PAC). With the exceptions of SCT and PAC, each of these pay definitions can use different assumptions and approaches, leading to multiple versions of realizable pay, for example.

Combining the lack of standard definitions with an increase in companies using alternative definitions in disclosures or shareholder communications is a recipe for confusion. A recent study of large companies found that about a quarter of them used alternative pay definitions last year. We expect this number to increase as companies become more proactive about “telling their story” on executive compensation.

As long as there are no common standards for pay definitions, there will be questions as to how the company arrived at its presentation. Companies want to respond to the limitations of the SCT, or to the approaches used by proxy advisors, but there is skepticism among shareholders as to whether the numbers presented in the alternative compensation presentations are comparable, understandable, cherry-picked for the best result, or will change from year to year.

Comparing the Definitions
There are large differences in calculating compensation numbers, depending on the definition used. These differences can and do lead to inconsistent conclusions on pay-for-performance alignment. The differences are caused, in part, by varied approaches to valuing the three primary components of equity long-term incentive awards: options, restricted stock, and performance shares.

The key issues, as outlined in a recent Farient research report (available at www.farient.com), include:

• Mismatched time periods for pay and performance.
• Different option valuation methodologies.
• Using target versus actual number of shares earned in performance share plans.
• Valuing stock as of the grant date, rather than what is actually earned.

Comparing the pay definitions on a company- by-company basis shows consistently wide variations in total compensation value. The difference between PAC and either realizable pay or realized pay is large, and affects many companies. Comparing realizable pay with PAC, for example, more than half (57 percent) of S&P 1500 companies had a greater than 10 percent difference in total compensation, while about one out of six had a difference of over 50 percent. Comparing PAC to realized pay shows even more disparity: nearly one-third of companies have a greater than 50 percent difference in pay results.

The differences for individual companies are even more striking. The variances in pay are large and widespread. Conclusions drawn regarding how well pay and performance are aligned can be swayed considerably based on the definition used. The choice of which “pay” definition to use is critical to correctly evaluating pay for performance.

Until there is greater consistency in the use of alternative pay definitions, investors will question the approach used and the credibility of the results. Some questions both companies and shareholders should ask about alternative pay definitions are:

• Is the definition used being applied consistently from year to year?
• Are the results comparable to other companies or unique to this company?
• Is the methodology clearly disclosed and tied back to the basic proxy presentation?

Jack Zwingli is leader of information services for Farient Advisors, which helps clients develop performance- enhancing and defensible executive compensation plans.

Dennis T. Whalen 

In our own ACI surveys, audit committees consistently point to the need for internal audit to “deliver greater value” to the organization. How can audit committees help ensure that internal audit is properly focused and fully utilized—and delivers the value it should? We offer the following suggestions:

Consider the need to redefine internal audit’s mandate. Internal audit is most effective when it is focused on the critical risks to the business, including key strategic and operational risks and related controls— not just compliance and financial reporting risks. Internal audit should constantly monitor how changes in the operating environment affect the business. In today’s global, digitized environment, a broad range of critical risks needs to be managed—from cyber security and social media; to risks posed by market expansion, M&A, and the global supply chain; to talent management and culture. Internal audit should be assessing these risks and associated controls. Leading internal audit functions are also reviewing the company’s overall risk management processes and working with management to continuously improve them. We’re even seeing internal audit being asked to take the lead in coordinating with other governance, risk, and compliance functions within the organization to identify duplication—and, more important, potential gaps—in coverage.

Ask how involved internal audit can or should be in these areas while maintaining the requisite focus on financial reporting and internal controls. To answer this question, and to get the most value from internal audit, the audit committee should work with management to determine the right balance of coverage. Competing expectations of the audit committee, CEO, CFO, business unit leaders, risk and IT officers, and others may, without proper planning, pose significant risks: internal audit may lose focus, the quality of its work may suffer, and its resource and skill-set requirements may be poorly defined. To minimize these risks, it is critical to have clear, company-wide agreement on internal audit’s mandate.

Make sure internal audit has the right resources and skill sets. With an increased focus on the company’s key strategic and operational risks, internal audit may need to acquire new skills—e.g., in IT, risk management, operational knowledge (supply chain, shared services, outsourcing), continuous auditing, data analytics, strategic planning, and more—by training, hiring new talent, or sourcing from outside service providers. Of course, the audit committee should continue to ensure the adequacy of internal audit’s resources and skills in the assessment of compliance and financial reporting risks and controls.

Reinforce internal audit’s objectivity and independence, and its accountability to the audit committee. As internal audit becomes more involved in helping the organization manage critical strategic and business risks and improve risk management processes, there is a greater need for the audit committee to help ensure internal audit’s “objectivity.” A direct, open line of communication between the audit committee and the chief audit executive becomes even more important, and here the audit committee chair plays the key role.

Internal audit should be moving toward a higher value-add model and functioning as an increasingly valuable resource—a trusted advisor and consultant—to the audit committee. However, this likely will not occur without the backing and support of the audit committee for internal audit to expand its mandate—with the right focus, resources, and independent perspective.

Dennis T. Whalen is partner in charge and executive director of KPMG’s Audit Committee Institute. Eric Holt is KPMG’s U.S. and global partner in charge of internal audit, risk, and compliance services.

Carol M. Baumer

Following are the 10 top risks reported by respondents across all industries, along with our commentary:

1. Regulatory risk: Heightened regulatory scrutiny affects the manner in which a company’s products or services will be produced or delivered. It is no surprise that regulatory risk ranks at the top of the list since few organizations and industries are immune to it. Without the effective management of regulatory risks, the organization is reactive at best and noncompliant at worst.

2. Economic conditions: The markets a company serves may significantly restrict its growth opportunities. Related to risks Nos. 3 and 4, growth is the name of the game. Companies are being forced to adjust to slower growth trends in some key markets.

3. Sovereignty risk/political gridlock: Uncertainty surrounds political leadership in national and international markets, and that leadership, or the lack of it, may limit growth opportunities. The challenge of adjusting to changes in the global economy, along with continued shifts in geopolitical dynamics, presents a complex, ever-changing picture.

4. Organic growth concerns: Clearly, growth through customer acquisition and/ or enhancement is better than decline, as managers believe they can hire and invest more in periods of growth than in periods of decline. Further, organic growth is less risky than growth by acquisition. In periods of decline or slow growth, it is harder to remain profitable, and can even be dangerous for highly leveraged companies. This rating from survey participants is consistent with the economic megatrends we are currently seeing in the slower-than-desired growth rate in the overall economy.

5. Succession/talent: The inability to attract and retain top talent and/or ensure leadership succession may limit a company’s ability to achieve its operational targets.

6. Financial markets/currencies: Volatility in global financial markets and currencies brings challenges. Significant financial risks in the form of emerging market, credit, currency, and other areas continue to be a concern. Few organizations are immune to the vagaries of the global economic and financial markets and the related impact on interest rates, credit availability, and currencies.

7. Cyber threats: Over the last two years, cyber attacks of unprecedented sophistication in multiple industries have resulted in the loss of intellectual property and business intelligence, and have the potential to significantly disrupt core operations. Since it is unlikely that all breaches have been reported, the sheer number and magnitude of malicious attacks highlight the need to better understand these threats and develop proactive solutions to mitigate their impact.

8. Security/privacy: Ensuring privacy and the security of information is a priority that can require significant resources for organizations to manage. Technological innovation, which just missed the cut as a top risk, is a powerful source of disruptive change of which no one wants to be on the wrong side. Cloud computing, social media, mobile devices, and other initiatives to use technology as a source of innovation and an enabler to strengthen the customer experience present new challenges for managing privacy, information, and system security risks.

9. Resiliency: Resistance to change arose as a concern because, as evidenced by the other risks that were top of mind for these directors and executives, it is indeed a risky world. In these uncertain times, it makes sense to increase the organization’s ability to change and adapt to a rapidly evolving business environment. Therefore, response readiness is important, as are the agility and resiliency of the organization.

10. Performance gaps: Today’s competitive environment demands that a company’s operations deliver performance levels at or above those of its competitors. Quality, time, innovative, and cost-efficient performance are as important as they have ever been.

Rarely has there been a greater need for organizations to understand and manage their risks than today. While views vary by industry, respondent, and size and type of organization, this top-10 list provides a great starting point for understanding the key risks in your company.

Carol M. Beaumier is executive vice president, global strategic planning, and Jim DeLoach is a managing director at Protiviti.

Robert J. Kueppers

By personality, we mean the ways in which a person tends to process information, to interact with others, and to reach decisions as evidenced by behavior. Defined in this way, personality may affect board dynamics as much as other composition considerations. Moreover, the combination of directors’ personalities can affect the chemistry within the board and between the board and management.

Many people think of chemistry as comfortable communication arising from serendipity. Yet the true source of chemistry results more from the mix of personalities in a group and the ways in which they interact. Thus in contemplating diversity, when evaluating current effectiveness or future needs, board members might well consider the personalities of existing and prospective directors.

Deloitte has developed a Business Chemistry model, which employs a data-driven approach to measure observable, business-relevant traits and behaviors. The model has been used with boards and executive teams who are seeking increased diversity and are interested in bringing personality into the discussion.

Can’t We All Just Get Along?
This Business Chemistry model defines four broad personalities: Driver, Pioneer, Integrator, and Guardian. These are purely descriptive; there is no best personality or mix of personalities. However, understanding your own personality and those of your colleagues can help improve communication, analysis, and decision-making.

Here are some common characteristics of the personalities identified by the model:

• Drivers are direct, decisive, skeptical, and goal-oriented, and are not consensus seekers. They process new ideas quickly and dislike small talk, waiting, and indecisiveness. They enjoy examining systems, can tolerate risk, and respond to logical arguments.
• Pioneers are imaginative, intuitive, energetic, and adaptable. They make decisions quickly, but can change their minds and have a high tolerance for risk. They dislike process, details, and repetition, and enjoy exploration, theory, adventure, and opportunities to explore ideas.
• Integrators are empathetic, diplomatic, supportive, and consensus seeking. They like the big picture and figuring out how the pieces fit. They dislike confrontation, competition, and aloofness. They weigh possibilities, develop understanding through stories, and have a tolerance for risk but tend to go along with the group.
• Guardians are methodical, detail-oriented, cautious, and deliberate. They like facts, rules, and hierarchy, and dislike theorizing, tardiness, disorder, and statements like “I feel.” They want proven principles and practices, order, rationality, answers to questions, and minimal risk and uncertainty.

Do these descriptions remind you of anyone you know? Although most people exhibit traits that overlap these categories, most hew to one dominant description.

Ideally, a board would include a blend of personalities. The resulting diversity of thought tends to foster inclusive discussions and well-considered decisions, but it can take work to maintain harmony and momentum.

The following guidelines for factoring personality into board diversity may be useful:

• Consider the impact of personality on the board’s interactions, engagement with management, and overall effectiveness.
• Understand your personality as well as those of fellow board members and senior executives.
• Decide which personalities may best support specific activities, such as oversight of strategy (e.g., Pioneer) or of risk (e.g., Guardian).
• Adjust your approach if you’re “talking past” someone, but realize that this adjustment may be difficult to sustain if you’re under stress.
• Recognize any resulting bias if the board lacks diverse personalities and tends to recruit like-minded members.

In providing advice and oversight, a board can benefit greatly from truly diverse viewpoints and frames of reference. Knowledge of personality can help a board achieve that diversity of thought.

Robert J. Kueppers is managing partner, Center for Corporate Governance, Deloitte LLP.

This article contains general information only and Deloitte is not, by means of this article, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this article. Certain services may not be available to attest clients under the rules and regulations of public accounting.

David N. Shine

In late 2012, Vice Chancellor J. Travis Laster and Chancellor Leo E. Strine Jr. of the Delaware Court of Chancery each issued a bench ruling discussing the appropriateness of “don’t ask, don’t waive” standstill provisions in confidentiality agreements.

In In re Complete Genomics Inc. Shareholder Litig., Laster enjoined Complete Genomics from enforcing a “don’t ask, don’t waive” standstill provision because, in his view, the clause impermissibly limited the board’s ability to meet its “statutory and fiduciary obligations to provide a current, candid and accurate merger recommendation” to its stockholders. Laster reasoned that because the “don’t ask, don’t waive” provision prevented the board from knowing whether another bidder was open to offering a higher price, it precluded the flow of information to the board and hindered its ability to determine whether to change its merger recommendation.

Three weeks later, in In re Ancestry.com Inc. Shareholder Litig., Strine, faced with a similar issue, noted that Delaware courts have been reluctant to create bright-line rules invalidating contract provisions, and refused to find that “don’t ask, don’t waive” standstills are per se invalid. Strine noted that such provisions can be employed by sellers as “value-maximizing” tools (a “gavel”) throughout the auction process. Nevertheless, he concluded that, in this case, Ancestry.com had failed to inform its shareholders of the use of the provision and that the board of directors had not appreciated its import in the auction process. Strine cautioned that the potency of these provisions requires a board to be cognizant of the provision’s effect throughout the sale process.

In short, these recent rulings highlight the continued importance of striking the right balance between the use of deal-finalizing tactics and the board’s continuing obligations to evaluate deal alternatives, and provide several takeaways for dealmakers and boards of directors. First, it is likely fair to conclude that “don’t ask, don’t waive” provisions are not per se illegal in Delaware and, accordingly, may continue to be used under the right circumstances and with the right process checks.

Second, a target board of directors should be well informed about, and consider, the pros and cons of these provisions before including them in a confidentiality agreement (which will involve a discussion with the board prior to circulating draft confidentiality agreements to potential bidders).

Third, if these provisions are included in the confidentiality agreement, the target board should revisit the appropriateness of maintaining them (and the desirability of waiving them) during the various stages of the sale process. A board could conclude that, depending on the facts and circumstances, it may make sense to unilaterally waive the provisions at some point during a sale process.

Finally, in negotiating the “deal protection” provisions of a merger agreement that allow a target company to provide confidential information to another bidder subject to execution of a confidentiality agreement, the target company should make sure that such provisions do not require the new bidder to agree to a standstill provision that would make it impossible to submit a superior proposal.

David N. Shine is partner at Fried Frank and co-chair of the law firm’s M&A advisory practice.

Because of China’s strict foreign currency control, U.S. companies may need to rely on their Chinese subsidiaries for transactions with Chinese customers, as only a China-registered company may collect the local currency, renminbi (RMB), in China. As the result, these Chinese subsidiaries may have accumulated substantial amounts of earnings. The strict foreign currency control means that many companies have difficulty finding flexible ways to repatriate the cash to their parent companies. That means that the cash “trapped” in China cannot be diverted to aid the company’s cash needs elsewhere.

This article presents some common strategies that U.S. multinational companies could use to improve their cash flow from China, as well as some concerns regarding these strategies.

Formulate the right business model to put the revenue with the preferred entities. One effective way to deal with the Chinese foreign currency control is to keep cash out of China. It may sound simplistic, but this approach requires some detailed planning to be effective. Although foreign companies may not collect RMB from Chinese customers, they can still sell to Chinese customers who are willing to settle transactions in foreign currencies, thereby diversifying at least part of their Chinese sales revenue out of China. A U.S. company could divide the Chinese market into two parts: 1) having a foreign company make the sales to the Chinese customers, who pay foreign currencies and are willing to handle the importing process; and 2) having a Chinese subsidiary take care of the sales to the Chinese customers who only have access to RMB.

Intercompany service fees. If a Chinese subsidiary relies on foreign-related parties for support, it should pay a reasonable service fee for that support. However, such a service fee should not be classified as a “management fee” because management fees are subject to special considerations. A disapproved management fee may not be deducted on a Chinese tax return while still being subject to withholding tax. On the other hand, fees paid by a Chinese subsidiary for specific services provided by related parties may be deducted on the entity’s income tax returns. Because an enterprise may not possess sufficient expertise internally to perform certain functions, it may seek such expertise from related parties. Like all other intercompany transactions, intercompany services should be conducted following the “arm’s-length” principle; transfer pricing documentation is required to sustain the intercompany pricing arrangements.

Royalties. Royalties are fees paid in relation to the use of intellectual property, such as patents, copyrights, trademarks, and proprietary technology. Different types of licensing agreements would involve approval/registration with different government authorities in China. Additionally, China limits the amount of total royalty payments to 5 percent of relevant sales revenue.

Interest. Having the Chinese subsidiary pay the interest for intercompany loans is another way to get cash out of China, although the process may be difficult. As with many things in China, intercompany loans must be registered with the Chinese government. If a foreign currency loan is not duly registered with the State Administration of Foreign Exchange, any remittance of interests or principal out of the country will not be allowed. The Chinese government also imposes some strict preconditions for an intercompany foreign currency loan to be approved.

Dividends. After a Chinese subsidiary’s statutory financial statements are filed with the government, the subsidiary may distribute a dividend based on the amount of available retained earnings. Chinese authorities should approve the dividend after the withholding tax is paid before any renitence. The procedure effectively limits a Chinese subsidiary to distribute one dividend annually. Also, the Chinese reserve requirement limits the amount available for distribution. Under the Chinese accounting rules, 10 percent of a foreign investment enterprise’s (FIE) current earnings should go into a reserve account, which may not be repatriated until liquidation. The ceiling of the reserve account is 50 percent of the FIE’s registered capital.

Because each of these strategies has certain limitations, experienced planners often employ a combination to achieve cash-flow efficiency, generate tax savings, and meet operational goals.

Frank Ji, Esq., CPA is the national China desk leader at McGladrey.

Dennis T. Whalen 

To help audit committees and boards rise to the challenges of the year ahead, we highlight key issues in our report, “KPMG’s Audit Committee Priorities for 2013,” that should be top of mind for every audit committee, including core responsibilities and broader governance matters in which audit committees can play an important role in supporting the board.

This year, audit committees face a host of governance challenges as economic uncertainty and political turbulence, globalization, digitization, increased government regulation, and stepped-up enforcement continue to reshape the business and risk environment.

How these issues fit into your committee’s agenda, of course, depends on how your company or industry is affected by each trend. But one notion has become clear: focused yet flexible agendas—and exercising judgment about what does and does not belong on the agenda, and when to take deep dives—will be critical.

Stay focused on job number one: financial accounting and reporting and internal controls. The noise in the room surely has escalated with ongoing public policy initiatives, debates on healthcare and tax reform, and new accounting standards. Still, the audit committee needs to stay focused on financial reporting quality, particularly with respect to monitoring fair-value estimates, impairments, and management’s assumptions underlying critical accounting estimates. Are all financial communications consistent with regulatory filings? Do the CFO and finance organization have all the resources they need to succeed? Remember, financial reporting quality starts with management.

Reinforce audit quality, and set clear expectations for the external auditor. An engaged audit committee enhances audit quality by setting the tone and expectations for the external auditor, and then monitoring auditor performance through frequent, quality communications and a rigorous performance assessment. Also, pay close attention to PCAOB initiatives on audit quality and auditor independence, and consider how the audit committee can strengthen its oversight.

Monitor the impact of the business and regulatory environment on the company’s compliance programs. Global supply chains and emerging technologies have made companies more vulnerable than ever to fraud, misconduct, and compliance risk. Take these into account for all growth initiatives, including new business partnerships. Ensure that the company’s regulatory compliance and monitoring programs are adhered to throughout the organization, and reinforced in locations both near and far from headquarters. Also, consider how vendors and other third parties fit into those programs.

Understand the company’s significant tax risks and how they are being managed. Challenged by the complexity of operating globally in different tax regimes, companies are facing new scrutiny at all levels, as well as demands for greater transparency and disclosure. To stay abreast of evolving tax risks, establish a clear communications protocol for the chief tax officer in order to update the audit committee on tax risk management and developments.

Make sure internal audit is properly focused and fully utilized. Internal audit is most effective when it is focused on the critical risks to the business, including key operational risks and related controls—not just compliance and financial reporting risks. Therefore, challenge internal audit to take the lead in coordinating with other governance, risk, and compliance functions within the organization to limit duplication in coverage and, more importantly, to prevent gaps. Internal audit should be a valuable resource to audit committees.

Beyond these core areas of oversight, audit committees can play an important role in supporting the board (and coordinating with other board committees) on a broader range of governance challenges:

• Consider whether the board has the right composition and committee structure to provide effective risk oversight.
• Understand how digitization and social media are transforming the business landscape and impacting the company and board oversight.
• Set the tone, and closely monitor leadership’s commitment to that tone as well as the culture throughout the organization globally. We invite you to read the full version of “KPMG’s Audit Committee Priorities for 2013” at www.kpmg.com/acpriorities.

Dennis T. Whalen is partner in charge and executive director of KPMG’s Audit Committee Institute.

Nels Olson

But boards should not stop at recruitment if they want their efforts to really pay off. Rather, they should support the new director’s integration into the board over an initial period to set him or her, and the board, up for success.

The first step before adding anyone new to the board is to understand the strategic reasons for doing so. It’s easy to be swept along with what is viewed as the latest board-recruiting trend, in this case the 20-something wunderkind with new-age skills that may be lacking on the board. Resist that impulse.

The place to start, as always, is to carefully consider the company strategy, then determine what skills and experience are called for on the board to support the strategy, take stock of what the board already has, and identify gaps in capabilities. If that analysis determines that a younger director who possesses limited, if any, board experience can provide needed skills, by all means go full steam ahead, albeit with the customary thorough vetting process as well as with realistic expectations and a thoughtful plan.

It is important to recognize at the outset that younger directors with limited board experience may have a higher credibility hurdle to get over and a steeper learning curve before they are able to contribute on a par with more experienced co-directors.

Expect some skepticism from established directors when adding a new director who combines youth and inexperience along with coveted skills. But board culture and process can be learned and, remember, part of the value the new director brings is a fresh perspective on key issues as well as real-world experience in an area that has been targeted as important to the board.

For any new candidates a board is considering, and especially for someone with less of a business and board track record, determining proper fit with the rest of the board team is essential. Rely on proven assessment tools and enlist current directors by making sure the nominating/governance committee and the rest of the board have realistic expectations and are prepared to do their part in helping to integrate the new director.

An effective on-boarding program and orientation should be established for any new director but, again, it is even more important to bolster an inexperienced director to become a contributing member of the team as soon as possible. Many companies have their own formal on-boarding process. For those that do not, fortunately there are many quality programs available, provided by the NACD and others.

In the case of a younger director, the board may also want to consider forging a mentoring relationship as part of the on-boarding process. Teaming an experienced director, who can be both guide and confidant, with a new recruit can help to accelerate the integration process considerably.

Any board that has expended the time and effort to attract and recruit a first-time director with much-needed skills to the board should not stop there if it wants the relationship to produce desired results. Investing in a process designed to smooth the way for a new director, and incidentally bring the rest of the board along, will greatly increase the odds that the experience will be a valuable one for both the director and the board.

Nels Olson is vice chairman and co-leader of the Board & CEO Services Practice at Korn/Ferry International.

Caroline Sng

Abolishing the Headcount Rule
Under the existing regime, a scheme of arrangement requires approval of a majority (Headcount Rule) representing at least 75 percent of the votes present at the meeting. For schemes of arrangements in a takeover context, the New CO will abolish the Headcount Rule but will require that not more than 10 percent of disinterested votes be cast against the resolution.

Director’s Duties
The New CO will codify a director’s duty of care, skill and diligence with a view to clarifying the legal position. A mixed objective/ subjective standard will be adopted, requiring a director to exercise the care and skill of a reasonably diligent person who has the general knowledge necessary to carry out the job.

Share Capital Maintenance
Currently, a reduction of share capital requires a special resolution and a court order confirming the reduction. The New CO will introduce an alternative court-free procedure where the special resolution is supported by a solvency statement made by each director confirming the director’s opinion that the company will be cash-flow solvent immediately after the transaction and for a period of 12 months thereafter. The New CO will also allow companies (not just private companies, as is currently the case) to purchase shares out of capital, subject to meeting the solvency test described above.

Financial Assistance
Under the existing regime, subject to certain exceptions, companies are prohibited from giving financial assistance to third parties that are purchasing the company’s shares. Private companies may seek a “whitewash” approval by special resolution from shareholders to permit financial assistance.

The New CO will allow companies (whether listed or unlisted) to provide financial assistance, subject to the satisfaction of the solvency test and either (a) board approval only, if the aggregate amount of the assistance does not exceed 5 percent of shareholders’ funds; (b) board approval and unanimous approval of shareholders; or (c) board approval and approval by ordinary resolution of shareholders, with notice given to shareholders of the assistance and subject to a right of dissenting shareholders representing 5 percent or more of the votes to petition the court for a restraining order. The New CO includes other important measures:

Enhancing Corporate Governance

• Improves written resolution procedures.
• Reduces the threshold requirement for members to demand a poll from 10 percent to 5 percent of voting rights.
• Requires public companies and larger private companies to prepare a more comprehensive director’s report, which includes an analytical and forward-looking business review.
• Improves a director’s conflict of interest procedures.
• Requires disinterested shareholders’ approval in cases where shareholders’ approval is required for transactions of public companies and their subsidiaries.
• Extends the scope of unfair prejudice to cover “proposed acts and omissions.”
• Empowers auditors to require a wider range of persons to provide information, and extends the offense of failing to provide information to the auditors.

Ensuring Better Regulation

• Introduces new secrecy rules for persons involved in an investigation.
• Strengthens the enforcement regime for contravention of the New CO.

Facilitating Business

• Allows companies to dispense with annual general meetings by unanimous shareholder consent.
• Introduces a new court-free statutory amalgamation procedure for wholly owned group companies.
• Facilitates simplified financial reporting by small and medium-size enterprises.
• Allows companies to execute deeds with the signature of two directors or a director and the secretary.

Modernizing the Law

• Adopts a mandatory no-par value system for companies with share capital.
• Clarifies the rules on indemnification of directors against liabilities to third parties.

Carolyn Sng is a corporate partner in Fried, Frank, Harris, Shriver & Jacobson LLP’s Hong Kong office.

Elizabeth Saunders

How high are the stakes? Respondents stated that on average, more than half (53 percent) of their investment decisions are based solely on the incoming CEO’s reputation. When CEOs are brought in to face the difficult challenge of reinvigorating growth or launching a growth strategy, the importance of reputation rises to 59 percent and 64 percent, respectively.

This connection between CEO reputation and investor decisions has profound consequences on whether enterprise value is gained or lost in leadership transitions and how to manage the succession strategy with key stakeholders. Communicating the incoming CEO’s reputation to key stakeholders takes an understanding of the skills they value most. For example, a large majority (70 percent) rated problem-solving skills as the most important attribute in a successful CEO, much more than cognitive abilities (10 percent), e.g., intelligence. Respondents also favored the selection of growth CEOs who have operational backgrounds—twice as much as those with sales backgrounds.

Wall Street also values proven leadership— individuals who have held the CEO job in the past—not typical for an incoming CEO. Only 37 percent of the chief executives evaluated had previous CEO experience. The challenge for the board is to develop a reputation for the new leader in the marketplace by creating a transition narrative and communicating it to stakeholders before the first in-person interaction.

Bryan Armstrong

What should a board consider during such a transition? First, don’t be lured into complacency or a false sense of security that stakeholders will trust that the board’s internal due diligence process produced the best CEO candidate. Consider expanding the succession strategy to include external candidates, preferably individuals with previous CEO experience, and communicate the breadth of the CEO search process.

Second, if the new leader ultimately comes from within the organization, the transition narrative must emphasize his or her previous leadership roles and relevant experience, highlighting key strengths and addressing potential areas of concern. If he or she lacks prior CEO experience, highlight his or her role as head of a division or business unit that experienced success. If the new CEO has both sales and operational experience, emphasize the latter, knowing investors prefer CEOs with operations expertise over candidates with sales skills. Ditto the ability to solve problems.

Finally, anticipate investor backlash well before making the actual CEO announcement. Make sure your company’s communications team has a full plan to communicate the transition narrative to key stakeholders and is ready to answer the difficult questions. The plan should address operational experience, reputation within the industry, and the new CEO’s ability to uniquely understand and move quickly to address growth initiatives because of his or her deep experience. Indeed, boards should give as much attention to how investors and other stakeholders might react to their decision as they give to the decision itself.

Context is everything—hence the wisdom in an assiduously crafted succession narrative persuasively conveying that the heir apparent has the experience, credentials and personality befitting a successful CEO. Timing is equally important: announce too early and investors have more time to question, and challenge, the merits of the candidate or the efficacy of the succession process; announce too late and speculation rises that the decision may not have been as orderly as advertised.

The survey findings emphasize the impact on enterprise value caused by a hastily conceived CEO succession strategy. The stakes are high, as the passing of the torch almost certainly resets investor expectations.

Elizabeth Saunders is Americas chairman and Bryan Armstrong, CFA, is managing director of strategic communications at FTI Consulting. Full survey results can be found at ceotransitionstudy.com.

In our latest global audit committee survey, more than 1,800 audit committee members from around the world shared their views on a range of issues, from oversight of financial reporting and audit quality, to risk management and the challenges posed by globalization, digitization, increased government regulation and enforcement. Here’s a snapshot of what some 700 audit committee members in the U.S. told us:

Dennis T. Whalen 

While virtually all respondents are either satisfied (88 percent) or somewhat satisfied (11 percent) with the quality of the external audit, many said auditors could offer more industry insights and benchmarking. Regarding oversight of internal audit, only 49 percent are fully satisfied that internal audit delivers the value to the organization that it should, and only about half said the internal audit plan effectively focuses on the critical risks to the enterprise.

Risk management is a work in progress. Nearly half the respondents said their company’s risk management system “requires substantial work.” Only about 20 percent are satisfied that the risk management process “extends far enough into the horizon,” and about one in three are not satisfied with the company’s crisis-readiness plan. The lowest ratings on risk-related information quality are in the areas of cybersecurity, global systemic risk and the pace of technology change. Only about 35 percent are satisfied that the audit committee hears dissenting views regarding the company’s risk and control environment. And just one in three said their company has in place an external social-media monitoring program to help identify emerging risks.

Perhaps most important, only about half said they are satisfied that their company’s governance activities—risk management, controls, compliance, crisis response, strategy and board oversight—are “properly focused on the risks that pose the greatest threat to the company’s reputation and brand.”

By design or default, many audit committees today have oversight responsibilities for a range of risks beyond financial reporting and controls (e.g., legal/regulatory compliance, technology and cybersecurity) as well as for the risk process generally. That said, 42 percent rated their audit committee as only somewhat effective in risk oversight, including understanding the audit committee’s risk oversight role.

Government regulation and global compliance are front and center. Along with economic and political uncertainty, audit committee members cited “government regulation and the impact of public policy initiatives” as a top challenge facing the company. From Dodd-Frank and health care to tax and fiscal reforms, the uncertainties and potential impact of government regulation and macroeconomic policies are front and center. More than 40 percent of survey respondents said their audit committee has increased its focus on global compliance in light of stepped-up enforcement of anti-bribery laws (e.g., FCPA and U.K. Bribery Act).

Expertise and better self-evaluations would help. Nearly 70 percent of survey respondents said their audit committee would be most improved by additional expertise (e.g., in IT, risk, M&A and industry knowledge). Other keys to strengthening effectiveness: greater diversity of thinking and backgrounds—including “fresh thinkers.” One in four said the committee’s current self-evaluation is not as robust and effective as it could be.

These and other key findings from our survey (at www.kpmg.com/aci) can help audit committees, boards and businesses benchmark current practices and spark fresh conversations about strategy, risk and governance, and the role of the audit committee, as they shape their 2013 agendas.

Dennis T. Whalen is the partner in charge and executive director of KPMG’s Audit Committee Institute.

Keith T. Wallace

Lots of Cash, but Is It Accessible?
Most multinational companies are emerging from the global financial crisis only to face other considerable challenges, such as the U.S. fiscal cliff and the eurozone economic issues. Many of these companies might give the impression they are well situated to face these challenges given the significant amounts of cash on their consolidated balance sheets. While this is an overall positive position, strong consolidated cash balances don’t necessarily translate to equally strong liquidity. This is particularly true when a company has implemented global cash management and tax-planning strategies resulting in a large portion of the balance residing in foreign jurisdictions. In these situations, it becomes important to understand how accessible the cash is and the repercussions of repatriating it to the U.S. For multinational companies based in the U.S. that have taken this global approach, it’s important to remember that the U.S. entity remains responsible for making many of the organization’s large corporate payments, including payments for principal and interest on corporate debt, dividends, share repurchases and pension contributions. While a company’s consolidated cash balance might indicate the company is flush, the reality might be that only a small portion of the balance is readily available. Directors need to understand whether management has completed and documented a global cash and liquidity assessment considering situational and daily operational pressures on the company’s liquidity. To do so, directors should consider the following questions:

In which jurisdictions does the company hold cash? And how much is located in each? It is only after understanding the location of the cash on a jurisdiction-byj-urisdiction basis that the impact of repatriating it to the U.S can be understood and assessed. Holding cash in some jurisdictions is more risky or complicated than holding it in others. For example, some countries require government approval to transfer cash out of their jurisdiction, which may take significant time and documentation to obtain.

What are the tax consequences associated with repatriating cash? Repatriating cash from a foreign jurisdiction to the U.S. can have significant tax consequences. If that is the case, repatriating cash to the U.S. will result in the company having much less cash available overall. These tax consequences are among the reasons many companies currently have a disproportionate share of cash in foreign jurisdictions.

How would the income statement be affected by the repatriation of cash? Repatriation of cash can have a significant impact on financial statements. Assuming the company previously took the position that earnings in a foreign jurisdiction would be permanently reinvested in that jurisdiction, which is a very common position, there could be significant tax expenses affecting net income. Net income would be affected by the realization of foreign currency gains or losses for intercompany loans that were previously considered to be long-term investments in nature. If these loans are no longer considered long-term investments in nature, the foreign currency gains and losses would be reported through net income rather than as a component of other comprehensive income.

How should directors assess the company’s current global liquidity? Directors should have open and candid discussions with management regarding the nature of the company’s consolidated cash balance and the effects of where this cash is located on the company’s overall liquidity. In fact, it could be considered a best practice for management to include an evaluation of the company’s consolidated cash balance and liquidity assessment in the audit committee (and the board) reporting packages. This documentation provides directors with management’s assessment of the company’s global cash position and its effective global liquidity along with contemporaneous documentation to support its disclosure in the Form 10-K and financial statements.

Keith T. Wallace is a partner and international assurance practice leader at McGladrey LLP.

Dennis Carey

Marissa Ann Mayer, who joined Wal-Mart’s board in April and who was formerly a top executive at Google, was named CEO of Yahoo on July 17, not long after she turned 37. Aspiring CEOs should take note: Board service at high-profile companies can catapult a career. And, unlike what we have seen in boardrooms across the country for many years, boards are finally paying attention to rising star.

According to the 2012 Fortune 1000 list, more than 1,100 directors on those boards are over 70 years old. But factoring in the ages of some of the newest additions to prominent boards—such as Starbucks (Clara Shih, 30, CEO of Hearsay Social), eBay (Kathleen Mitic, 42, marketing director of Facebook), Colgate-Palmolive (Nikesh Arora, 44, chief business officer of Google), and Monsanto (Jon Moeller, 48, CFO of Procter & Gamble)—that is beginning to change.

Several factors have contributed to the aging of boards. Retired CEOs have been recruited at a record pace and retirement age mandates eased to hold on to respected directors who “age out.” That has been chiefly to compensate

Robert Hallagan

for the lack of access to current CEOs, who are increasingly restricted to serving on one outside board or none at all. In addition, the crushing time demands of some boards have pushed nominating and governance committees to consider hiring “professional” directors, a cadre of retirees who take on several boards as their occupation. Finally, many directors have hung on to their seats beyond traditional retirement age as their companies struggled following the 2009 financial meltdown.

While we are starting to see the age curve trend downward toward including younger directors, board data, which reflect the prior year’s proxy, has not yet caught up. In our 2012 Korn/Ferry Market Cap 100 (KFMC 100), we noted that board turnover was a very low 7.6 percent of all board seats in fiscal year 2011. Thirty-one percent of directors had served on their current board for more than 10 years, and the average age of this group was 63. Now, as the economy begins to slowly come back from the financial crisis, we are seeing a new class of board recruits who are younger and possess specialized experience in:

• New global markets, from China to Brazil to Indonesia;
• A digital world with far-reaching implications for marketing and advertising;
• Social media and its impact on assessing consumer preferences at the touch of a smartphone button; and
• Cloud computing and its potential impact, from data retrieval and competitive pricing advantages to novel security issues.

At the same time, boards are being pushed to take a more active role in crucial issues such as CEO succession and talent management, as well as risk management, strategy and compensation architecture. But shifting criteria for what it takes to succeed in a radically transformed global economy present significant challenges for executives who have not been active leaders. Their wisdom and judgment are still valuable, but they will not have experienced this new complexity.

In the past, nominating and governance committees and CEOs stressed the need for candidates with “sufficient runway” to serve for perhaps five to six years post-retirement, meaning until their early 70s. Now those responsible for recruiting directors want to consider candidates in their mid-50s or even younger for their critical new skills.

As both this trend to attract younger directors and retirements proceed apace, now is the time to get into the market and hit the board refresh button. Opportunities to recast boards don’t come along often, and boards and CEOs should ensure the right mix of experiences and personalities to align with the strategy and challenges that lie ahead. Boards that do this best will emerge as winners in the coming talent war for the best and brightest directors.

Dennis Carey and Robert Hallagan are vice chairmen of Korn/Ferry International.

Jay J. Rittberg

In the past, disagreements over the scope of indemnification provided by sellers have scuttled many deals. Cases where deals have been approved despite low indemnification amounts have kept directors up at night.

In situations like these, one tool that is increasingly being utilized to close the deal and protect your company’s downside risk is representations and warranties insurance (RWI). In the example described, your company could bridge the difference between the parties by acquiring a $30 million RWI policy with a $10 million deductible, which would be paid out of the escrow account, as agreed to by the seller. Your company would then have protection for breaches of representations and warranties for up to $40 million, while the seller would be able to satisfy its goal of returning its proceeds to its limited partners.

While RWI has been in the marketplace for more than 15 years, it has only recently become a common tool used by creative dealmakers to resolve differences between buyers and sellers in complex M&A transactions.

Certain innovations over the past few years have helped to bring the product into the mainstream:

• Pricing: RWI used to cost as much as 5 to 10 percent of the amount being insured. Now most deals can be insured for 2 to 4 percent of the total limit being insured.
• Streamlined underwriting: RWI underwriters are now able to underwrite and bind coverage in less than a week, which allows RWI to be acquired without slowing down fast-moving transactions.
• Insured-friendly language: More than ever, RWI policies are able to match the indemnification language that a buyer would receive from a seller. The number and scope of exclusions in a standard policy have been reduced significantly, leaving few or no holes in coverage.
• International development: Use of RWI has spread worldwide, allowing participants in cross-border deals to obtain a policy in a jurisdiction that is relevant to the transaction and where they are comfortable with enforcing a judgment.
• Claims administration: As the product’s use has increased, millions of dollars in claims have been paid out for breaches of representations and warranties. The number of positive claims experiences reported by users has caused others to become comfortable using the product, and has driven repeated use by some acquisitive companies.

All of these developments have created a relatively inexpensive, user-friendly tool that can help to facilitate deals. In the case of the deal discussed earlier, with RWI, you could approve the acquisition on terms negotiated by your deal team and feel confident that you did your fiduciary duty by unlocking value for your shareholders, while protecting them from the downside risks inherent in any M&A transaction.

Jay J. Rittberg is vice president of the Mergers & Acquisitions Insurance Group at AIG. He can be reached at jay.rittberg@aig.com.

Sandy Pundmann

One of the primary roles of the board is to advise management in the development of a strategy that aligns with the mission of the organization and with the short- and long-term vision of stakeholders. The Deloitte LLP Governance Framework (shown below) focuses on five critical elements of a governance system in which the board needs to play an active oversight role: strategy, performance, governance, talent and integrity. In today’s changing regulatory landscape and the current economic uncertainty, the board’s role in strategy could not be more critical. Further, of all the strategic issues that compete as governance priorities, risk— either as a value creator or a value destroyer— is a common denominator to all.

Enterprise risk and strategy simply cannot be separated, and, while it is management’s job to present a strategy that incorporates appropriate risk emphasis, it is critical that the board advises, challenges and provides objective perspective as to the specific risks of and to that strategy. Boards that recognize the importance of strategic oversight, combined with how the enterprise thinks about and addresses risk, can lead the way.

Maureen Errity

A strategy that once worked well might fall short of expectations—or fail altogether— in light of new realities. Businesses have entered a new era in terms of how they need to think about strategy as it aligns with the company’s risk profile; the responsibility for challenging whether strategic direction has been appropriately vetted and optimized lies squarely with directors. It is as much about focusing on the risks to the strategy and whether the enterprise has the right strategy—one that takes calculated risks to create value—as it is about being aware of risks of the strategy—including those risks associated with the assumptions made about the strategy presented. Together, these drive the end game and help shape how well the management team’s portfolio of strategic options can deal with an unpredictable world.

The 2011 Board Practices Report, a study carried out by Deloitte LLP with the Society of Corporate Secretaries and Governance Professionals, showed that only half of respondent organizations discuss strategic objectives at every board meeting, and only about the same margin have increased the level of board involvement in strategy-setting despite recent marketplace challenges. The board provides important leadership in the strategic planning process and in the continuing dialogue of monitoring strategic objectives, by asking the right questions, building an open dialogue and consensus. Since effective strategic oversight depends on having the right information, the following questions provide an overview for a board to begin assessing whether their current process aligns strategy with risk. Does the board:

• Provide “active oversight” in developing the strategy?
• Engage appropriately and regularly on strategic objectives?
• Possess a good understanding of the risks to the strategy—those that may limit value creation or even cause the strategy to fail—and the risks of the strategy—those associated with each scenario of the strategy ?
• Ask probing questions, including those that challenge assumptions of the strategy presented?
• Have an understanding of the key risk indicators in place to alert decision makers to a strategic risk? What are the vulnerabilities?
• Assess potential new risks the strategy can create? Can those be managed?
• Prepare for if this strategy fails? What risks and rewards do other paths represent?

More organizations are making risk management a vital component of their strategic planning process. Ongoing, proactive oversight by the board can add significant value by bringing a more objective, bigger-picture perspective, and contributing a dose of healthy skepticism that keeps planning on track with company objectives and market realities, and that broadens the role of risk programs to include value preservation and enhancement.

Sandy Pundmann (left) is a partner at Deloitte & Touche LLP. Maureen Errity is a director at Deloitte LLP.

This article contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this article.

Marc Alpert

The SEC granted no-action relief to eight companies:

• In three instances, the SEC found that the proposal in question constituted multiple proposals due to a problematic “change in control” provision that the SEC concluded was a separate and distinct matter from the proxy access provisions.

Nicholas Scannavino

• In four instances, the SEC found that the proposal in question was vague and indefinite due to a problematic reference to SEC eligibility requirements that the proposal failed to describe.
• In one instance, the SEC found that the proposal in question was vague and indefinite because the proposed proxy access bylaw amendment conflicted with a provision in the company’s existing bylaws disclaiming shareholders’ rights to include director nominees in the company’s proxy materials.

The SEC denied no-action relief to six companies:

• In three instances, the SEC denied no-action relief where the company sought to exclude the proponent’s proposal as vague and indefinite based upon a website referenced in the proposal that was not yet functional at the time the proposal was submitted. The SEC noted that, among other things, the proponent had represented that it intended to include the information on the referenced website upon the company’s filing of its proxy materials.
• In one instance, the SEC denied no-action relief where the company sought to exclude the proponent’s proposal on the basis that it substantially implemented the proposal by unilaterally adopting a proxy access bylaw amendment with a minimum ownership requirement that differed from the proponent’s proposal. The SEC noted the difference in ownership levels required for eligibility between the adopted bylaw and the proponent’s proposal, but did not provide guidance as to whether a smaller difference in ownership levels would have led the SEC to conclude that the company had substantially implemented the proposal.
• In two instances, the SEC denied no-action relief where the company sought to exclude the proponent’s proposal because implementation of the proposal would violate state law. In each case, the SEC noted that the language of the proposal did not necessarily support an assumption made in the opinion of the company’s counsel that certain provisions of the proposal would impermissibly modify the fiduciary duties of directors in violation of state law.

Rather than seek no-action relief, several companies included proxy access proposals in their proxy materials and recommended a vote against the proposals. The companies that were denied no-action relief by the SEC did the same. Shareholders at only two companies—Chesapeake Energy and Nabors Industries—have approved the proposals.

Some companies agreed to take other actions. For example, one company agreed with a proponent to include a management proxy access proposal in proxy materials for its 2013 annual meeting that is very similar to the proponent’s proposal. Another proponent appears to have withdrawn its proxy access proposal, perhaps as a result of the company’s adoption of other corporate governance changes (including majority voting for director elections and the declassification of its board).

The number of proxy access proposals will likely increase over the next several years. Companies should therefore carefully evaluate their options and strategies with respect to proxy access proposals and procedures.

Marc Alpert is a partner and Nicholas Scannavino an associate in the corporate practice at the law firm Chadbourne & Parke. Contact them at 212-408-5100 or malpert@chadbourne.com and nscannavino@chadbourne.com. For a complete version of the survey, see the September 2012 edition of the Corporate Practice Newswire at www.chadbourne.com.

Dennis T. Whalen 

 

At a high level, the new standard has four objectives for the auditor’s communications with the audit committee:

• Communicate the auditor’s responsibilities and establish an understanding of the terms of the audit engagement with the audit committee
• Obtain information from the audit committee that is relevant to the audit
• Communicate an overview of the overall audit strategy and timing
• Provide timely observations arising from the audit that are significant to the financial reporting process.

Collectively, the communications that are incorporated into the new PCAOB standard help ensure transparency and a good understanding of the audit, the integrity of financial reporting and the state of the business—and clearly a well-informed audit committee is better equipped to monitor auditor performance and gauge audit quality.

But beyond any specific communication requirements, it’s critical that the audit committee and auditor have an open line of communication—particularly in today’s business and regulatory environment with financial reporting and disclosures becoming more complex. This new PCAOB Standard is more about meaningful conversations between the audit committee and auditor than it is about new information going to the audit committee.

As emphasized in the 2010 Report of the NACD Blue Ribbon Commission on the Audit Committee, a strong relationship—including frequent informal communications—between the audit committee chair and the lead engagement partner is critical, and often includes:

• Seeking the auditor’s input on committee agendas, walking through pre-meeting materials, discussing developments on a real-time basis and promoting an understanding of key matters from the perspective of the external auditor.
• Conducting an executive session with the external auditor at each formal meeting—to gain insight into the strengths and weaknesses of the company’s financial reporting and control processes and other relevant observations or concerns.
• Maintaining robust, two-way communications with the external auditor about a range of financial reporting, internal control and risk-related issues that may impact the company’s financial reporting and internal controls.
• Establishing clear expectations with the auditor regarding communications and interactions with the audit committee (related to the audit, progress reporting, issue resolution, the auditor’s support of the audit committee, etc.) and with management. If adopted by the SEC, Auditing Standard No. 16 would go into effect for public company audits of fiscal periods beginning after December 15, 2012. But audit committees and auditors alike should already have high expectations for the type of robust, two-way communications that are vital for each to carry out their responsibilities to investors and the capital markets.

Dennis T. Whalen is partner in charge and executive director of KPMG’s Audit Committee Institute.

Jane Romweber

There are many reasons for boards to request comprehensive performance information annually. These include due diligence, performance evaluations, support of the say-on-pay resolution and approval of goals for incentive plans.

What follows are suggestions for analyses that boards and committees should request of management where not already provided. Some are most appropriate for the full board, others for the compensation committee.

Board of Directors Analyses
A midyear board meeting offers an opportunity for a thorough discussion of performance. It also provides an opportunity for perspective since there is no business plan on the table for approval.

A full discussion of performance will include the following, with historical results covering five years or longer:

• External impacts:General analysis of the three to five most important external impacts on the company’s results, e.g., consumer spending, housing starts, interest rates, oil prices, regulatory outcomes, government spending, etc.

Jamie McGough 

• Actual results: History of actual corporate results, e.g., operating and net income, revenues, margin percents and total shareholder return (stock price increase plus dividends as a percentage of beginning stock price).
• Plan versus actual: History of business plan (and for the compensation committee, incentive plan) versus actual results with analysis of the differences. This provides information about the range of variances over the years, as well as clues regarding management’s bent toward optimism or pessimism in planning. A history of actual incentive plan payouts should be provided as well.
• Peer comparisons: History of actual results versus those of peers. Of interest is not only the percentile at which the company ranked, but also the range of results, since it can be instructive in evaluating the degree of stretch between threshold, target and maximum performance levels in incentive plans.
• Total shareholder return: History of total shareholder return compared to total shareholder return, with a discussion of where they diverge.
• Relative total shareholder return: History of total shareholder return versus other companies of significant size within the industry. Note that companies using relative total shareholder return in their long-term incentive programs may have already met this need.

Compensation Committee Analyses
With this information in hand along with the business plan, the compensation committee will be better armed to evaluate the short-term incentive goals proposed for the coming year. The committee can benefit from additional analyses, however, to provide context.

• Short-term incentive pay for performance: Recent short-term incentive payouts at the company and industry peers—expressed as a percentage of target to neutralize company size—compared to broad measures of success, such as operating income growth. Such an analysis provides a wealth of information, including median industry payouts as a percentage of target, correlations of payouts to various financial measures and the company’s placement in terms of performance versus payout.
• Sharing ratio: The relationship of the incremental bonus between maximum and target to the incremental earnings between the two points. When the incremental bonus represents a high proportion (e.g., more than 30 percent), it may be that the maximum earnings goal should be higher.
• Total pay realized versus performance: For CEOs with sufficient tenure (i.e., three to five years), a comprehensive review of actual pay realized versus performance in various measures compared to peers over a three- to five-year period. While such comparisons can be complex, when done well they are valuable in determining whether pay and performance have been reasonably commensurate over a multi-year period.

Summary
Boards and committees armed with the information above will be able to evaluate management’s performance and future performance goals, explain pay outcomes in the CD&A and craft support of the annual say-on-pay resolution more fully.

Jane Romweber and Jamie McGough are partners at Meridian Compensation Partners, an independent executive compensation consulting firm.

Dennis T. Whalen 

Survey findings from our latest KPMG Roundtable Series in more than 25 cities are telling: Only 39 percent of the 1,200-plus directors and senior management polled during the series said they are satisfied that their company’s governance activities are appropriately focused on the greatest risks to the company’s reputation and brand. Less than a quarter said they are satisfied that key governance activities are aligned with the company’s risk hot spots, and that the company’s governance activities are integrated into the strategy and add “real value” beyond simple compliance.

KPMG’s Roundtable Series highlighted a number of ways that boards can help assess whether a company’s governance activities are keeping pace in a fast-changing environment:

Understand the company’s risk hot spots and how the company monitors and manages these risks. Specific risk hot spots vary by company and industry, but typically they include emerging technologies/new IT systems, disruption of the business model, cybersecurity and the protection of IP, globalization and systemic risk, the extended global organization (vendors and suppliers), M&A, compliance and government regulation, business transformation and changes in the operating environment. In light of the volume, complexity, pace and interconnectivity of these risks, boards should be asking not only whether risk management is keeping up, but whether all key governance activities are keeping pace together.

Do key governance activities have a shared view of the company’s risk hot spots? Every company has a number of governance activities or “lenses” through which its risk hot spots are viewed—e.g., risk management, contingency planning, financial reporting and controls, compliance, internal audit, strategic planning and execution, and ultimately board oversight. Are all of these perspectives and moving piece-parts in sync? No one size fits all, but the right governance framework—driving the right culture and tone throughout the organization—can help ensure that various governance activities are coordinated and integrated into the strategy to add “real value” beyond simple compliance (e.g., so that strategy and contingency plans can be recalibrated as the risk environment changes).

The audit committee is uniquely positioned to help ensure alignment. At a time of dramatic change in the business environment, the risk of misalignment of governance activities can be high (e.g., the company’s supply chain or IT systems may be undergoing critical changes, posing new risks to be managed and requiring new mitigation activities, controls and contingency plans). The audit committee—perhaps in coordination with other board committees, such as a risk or compliance committee—can serve as a catalyst to help ensure alignment, as it typically has oversight responsibility for, or at least substantial involvement in, so many of the company’s core governance activities. The audit committee also can help set the tone and culture regarding the importance of governance, including elevating the stature of management responsible for key governance activities (e.g., general counsel, CRO, chief information officer, chief compliance officer and chief audit executive).

Set expectations and spot gaps. A key role for the board and audit committee is to help set expectations for an integrated approach to governance (i.e., is there a single up-to-date “governance view” of the enterprise?), and to help identify potential gaps. Who is responsible for identifying and monitoring risk hot spots on a real- time basis, and aligning governance activities accordingly? What roles do the CEO, CFO, GC, CRO and CCO play? Is internal audit properly focused and resourced? Are the roles of the board, audit committee and other committees in overseeing key governance activities clear?

Also consider whether the board and the audit committee are keeping pace. Do they have the resources, agenda time, expertise and boardroom culture to effectively challenge and advise management in these times of rapid and dramatic change? Are the board’s governance processes keeping pace with technology, globalization and business change?

Dennis T. Whalen is partner in charge and executive director of KPMG’s Audit Committee Institute.