If uncertainty was the rule of order for audit committees in 2010, then risk and compliance concerns are topping their agendas today. More than a dozen public company directors, along with economists and thought leaders on corporate governance, convened for a roundtable dialogue to kick off the seventh annual Audit Committee Issues Conference. Amid concerns of a tepid economic recovery, rising federal and state deficits, new government regulations and an array of evolving business risks, this year’s conference—hosted by KPMG’s Audit Committee Institute, NACD, Weil Gotshal & Manges and the University of Miami— helped crystallize what lies ahead for today’s public company boards and, more specifically, the neverending work of their audit committees.
Left to right: Donna Shalala, Jim Liddy, and Mary Pat McCarthy
The growing complexity of business—compounded by new government regulations and accounting standard convergence, an increasingly difficult compliance environment and the ongoing white hot scrutiny of shareholders and media alike—moves risk and crisis management to the forefront of audit committee agendas.
Set aside other top concerns for a moment and consider the sheer volume of legal and regulatory compliance requirements. Dennis Beresford, whose significant board experience spans a decade—including Fannie Mae, Kimberly-Clark and Legg Mason—said this daunting set of issues is driving some audit committees to re-evaluate and in some instances beef up their company’s internal compliance processes and resources. Depending on the nature of the company’s business, compliance related to financial reporting, taxes, and industry-specific regulations from, for example, the Federal Communications Commission or Food and Drug Administration —not to mention whistleblower programs and the Foreign Corrupt Practices Act (FCPA)—have added new levels of complexity and risk.
Based on his experience as an advisor to audit committees, the challenge of dealing with the volume of information audit committees receive about these and other risks facing the enterprise is a growing concern, said KPMG Vice Chair of Audit Jim Liddy. “One of the things I tend to see many boards struggling with is how to sort through all the information they receive. They are being inundated with data and oftentimes it’s difficult to understand how that data can help them accomplish their oversight objectives. What is the information they need and how can they process and analyze that information to gain important insights and ultimately offer helpful advice and make good business and governance decisions?”
Left to right: Alex J. Mandl, Donna Zarcone and Bart van Ark
Interestingly, information technology skyrocketed onto the short list of top audit committee oversight concerns this year in a KPMG Audit Committee Institute poll of some 120 audit committee members attending the Audit Committee Issues Conference in February. In addition to an increase in cyber-related crimes, what’s driving those concerns, according to one director, is that hackers seem to be getting more sophisticated and corporate security systems are not keeping pace. And the adoption of emerging technologies—such as cloud computing— and the implications of WikiLeaks and other social media risks are sparking more rigorous discussions with the CIO.
Audit committees also sit on the cusp of what Tom Duffy, KPMG’s national managing partner for audit, described as the “biggest standard-setting agenda scheduled to unfold in a very concentrated period of time—the greatest change in accounting that most of us have seen in our careers.” It is clear that significant change to U.S. accounting is on the way as a result of joint activity of the FASB and IASB.
Teresa Iannaconi, a partner in KPMG’s Department of Professional Practice and former deputy chief accountant in the SEC Division of Corporation Finance, pointed out that FASB Chair Leslie Seidman has publicly committed to issue final accounting standards by June in five key areas. While that schedule may prove to be ambitious indeed—with year-end 2011 being a more feasible timeframe—Iannaconi emphasized that these new standards (and others to follow) will bring profound change to U.S. GAAP and the way companies and investors report and interpret corporate financial statements.
What Audit Committee Members Said
On the upside, however, resolution around accounting standards can benefit those companies pushing into new markets, said board director Alex J. Mandl. “To be able to effectively do business there and control that business from an auditing point of view requires that you learn and adopt the appropriate auditing systems and operational procedures. As you extend [your companies] into new parts of the world, that burden becomes enormous.”
Left to right: Irvine O. Hockaday Jr., Holly J. Gregory and Barry A. Fromberg
Irvine O. Hockaday Jr., who serves on the boards of Crown Media Holdings, The Estée Lauder Cos., and Ford Motor Co., sees great risk—no pun intended— of directors conflating their roles concerning risk oversight, business advice and counsel and risk management. The right balance is crucial and will fluctuate with particular circumstances. The risk environment is constantly changing, and directors need to assess whether they and their board are in a position to understand the implications of these changes for the company.
According to Hockaday, “This is an opportunity to take a step back and look at the composition of the board in the context of the company’s strategy and risk profile today and for the next several years.” There is a real need for a rigorous self-evaluation process, “and in my experience,” he said, “it’s pretty perfunctory.”
The chairman of MG Advisors, Mary J. Steele Guilfoile, who serves on the boards of Interpublic and Valley National Bancorp, wants to make sure that audit committees don’t become overly focused on “process”—checking boxes, dotting i’s and crossing t’s. “With the regulatory scrutiny we’re all under, it would be very easy to get caught up in a lot of process, rather than spending the time doing what is most productive in terms of benefitting shareholders, which is to really learn about the business and its inherent risks. That’s what our job is really about,” she said.
And, as CEOs may tend to view risk through a business opportunity lens, audit committees often must force the issue. To that point, Mandl suggested that the process of risk management be integrated into the strategic planning process so that the two are interwoven and there are proper checks and balances.
There is no substitute for industry knowledge, and boards need to have directors who truly understand the business, noted Adrian Tocklin, a director who serves on the audit committee of Thrivent Financial for Lutherans.“I am a much better board member when I know the business from top to bottom because you can’t understand the risks if you don’t understand the business.” Directors with deep industry knowledge become important sources of information for other board members and can help promote the healthy skepticism that is a defining characteristic of an effective board.
Another challenge for boards—and another popular image stemming from the financial crisis—is the strong willed, “imperial” chief executive, daring to be questioned. The downfall of once high-flying Wall Street firms such as Bear Stearns and Lehman Brothers, as well as Tyco and Enron almost a decade before, had average investors and corporate governance experts alike asking: Where was the board?
Left to right: Mary J. Steele Guilfoile, Adrian Tocklin and J. Thomas Presby
J. Thomas Presby, whose varied board work currently includes ExamWorks Group, First Solar, Invesco Ltd., Tiffany & Co. and World Fuel Services, has observed CEOs who attempt to manage their boards by controlling the flow of information or by causing the board to name an executive committee consisting of a few members who happen to be close colleagues. The executive committee, rather than the full board, can then become the forum where the most sensitive issues are covered. Cases like these, where the culture is one of control rather than collegiality and transparency, are strong arguments for the separation of the chairman and CEO roles. However, it is important to remember that each particular set of circumstances requires the governance structure best suited to it.
Presby also pointed out that “you can’t fault the CEO when he or she behaves like one. Strong leaders, like the ones who make it into the C-suite, will want to manage everything important around them. This will include managing the board if the board permits it. Board members need to keep in mind exactly which body is governing which. I emphasize that this is a matter of managers’ DNA rather than sinister or sneaky motives. They simply can’t help themselves…It’s just another challenge for the independent directors.”
One participant described an approach—shared by an audit committee chair of a major company— that was used to set clear expectations regarding the board’s relationship with the CEO. Prior to its first board meeting, the audit committee chair met with the company’s new chief executive to present a one-page description of how the board planned to interact with the new CEO and management. “The paper essentially said, ‘We’re going to question. We’re going to be skeptical and we’re going to ask for alternative viewpoints. And it doesn’t mean we don’t trust you. And it doesn’t mean we don’t like you. But this is how we as a board are going to operate.’ That strikes me as a very direct and constructive way of establishing good, healthy skepticism and dynamics.”
Left to right: Steven Hill, H. Raymond Bingham and Dennis R. Beresford
Listening to the discussion unfold, H. Raymond Bingham, whose current directorships include Oracle; Flextronics International, where he is chairman of the board; and STMicroelectronics, challenged audit committees to improve their knowledge by increasing the investment made to understand the business from a strategic and operational sense. “When you get the answer to the question that you’re inspired to ask, you also need to understand the implications of that answer to the strategy, risk and vitality of the business. And that goes for every director, but audit committees in particular, should always focus on raising their game in this respect.”
Barry Fromberg, a director at Constellation Brands and Xtera Communications, agreed that strategic focus is crucial. “I see boards spending a lot more time on understanding the strategy and where the company’s big bets are. As growth returns, how well are we positioned to take advantage of the opportunities out there?”
What the Educator Said
“Every board I sit on wants to know what the bottom line is on healthcare,” said Donna Shalala, the University of Miami president who for eight years served as Secretary of Health and Human Services under President Bill Clinton and now serves on the boards of Gannett Co., Lennar Corp. and Mednax. Shalala recommends that boards ensure there is a corporation-wide analysis of a company’s healthcare usage and data.
As head of the largest employer in Greater Miami—some 13,500 workers report to the university each day—Shalala says it doesn’t matter whether you’re a Republican or Democrat, the medical system needs cost containment. Even so, she predicted that states will battle the federal government and raise questions of constitutionality that will ultimately lead to the Supreme Court.
Asked by a director for specifics on what the University has done to help control employees’ medical costs, Shalala said, “You know, everybody believes that individuals ought to have more of their own dollars in the system so that they are sensitive. We’ve tried everything from higher co-pays to higher deductibles and wellness programs including smoking cessation…but people need to be educated at the micro level.” Shalala is adamant that the new so-called “Obamacare” signals the beginning of a necessary systemwide change.
What the Economists Said
The enactment of Obamacare could cost upwards of $800 billion over the next 10 years while the United States deficit as a percent of GDP hovers near an alltime high of 10 percent. Turning from the subject of healthcare, Moderator Jeffrey M. Cunningham queried economist David Hale on the prospects for “meaningful deficit reduction and what the ramifications are if you in your heart don’t believe that the American people have the willpower?”
Left to right: Jeffrey M. Cunningham, Tom Duffy and Teresa E. Iannaconi
Since President Barack Obama’s state of the union address took place just days before the Issues Conference convened in Miami, Hale remarked that the President made only a cursory comment about corporate tax reform and provided no details, a powerful signal that “on the Administration side, I don’t see a lot of movement” on deficit reduction.
And what happens if there isn’t deficit reduction? Ultimately, warned Hale, “the solution will be some kind of national crisis…If we make no progress on deficit reduction, and trillion-dollar deficits continue indefinitely, in 2013 or 2014 the government bond yield would be 9 or 10 percent and then you’d have a real panic, a real fear.”
The Conference Board’s chief economist, Bart van Ark, sees significant challenges and opportunities in the U.S. and global economies. “There are very real risks right now in the emerging markets, including inflation, possible asset bubbles, and maintaining sustainable growth,” he said. On the upside, van Ark points to significant gains in U.S. productivity, as well as advancements in technology and innovation. “The United States clearly has an important opportunity to lead in these areas.” And he agreed with the general sentiment among Roundtable participants that a longterm, strategic view is critical for companies at this pivotal point in the global economic recovery.
What the Examiner Said
“What I’ve seen, not just with Lehman Brothers but with other institutions, is that the problems are frequently known, or can be known if the board is prepared to ask [the CEO] for dissenting opinions. It’s a simple question: ‘I see what you have to say. Now, are there any other individuals in the organization who have a different opinion?”
Left to right: Anton R. Valukas, David Hale and Ram Charan
So began Anton “Tony” R. Valukas’ recounting of his experience as the court-appointed examiner in the Lehman bankruptcy, the largest in American history—greater than Enron, WorldCom, Washington Mutual and CIT combined. Valukas, who is chairman of the law firm Jenner & Block, assembled a team that studied the causes of Lehman’s demise detailed in a 2,200-page report issued last year.
Valukas addressed the questions that directors most want to know: what happened, how could it have happened and what are the lessons for boards? In short: Management believed that a countercyclical strategy would be profitable despite the market signals that suggested caution. The mantra was “pedal to the metal,” he said, and the board ratified management’s strategy, which, in retrospect, might have been scrutinized and challenged in greater detail. Just eight months before Lehman declared bankruptcy, it announced its most profitable year.
When Valukas spoke at the NACD Directorship 100 Forum in November (see NACD Directorship, February/March 2011) and again before this audience of audit committee members, his message was clear: “Lehman failed because of its own decisions to increase risk.” While there were regulatory failures within the SEC and the Federal Reserve and structural failures within Lehman itself, the core issue, according to Valukas, stems from management’s failure to understand and accurately measure the extent of risk at this once formidable financial institution and the board’s failure to more aggressively question management on its strategy to take on more risk.
Valukas suggests that directors and members of all board committees need to exercise healthy skepticism. More probing questions—including: Are we hearing dissenting views from people down the line?—might have helped the board steer Lehman on a different, safer course, noted Valukas, acknowledging that the board did not have the benefit of knowing then what we know now.
What the CEO Guru Said
When the globe-trotting management expert Ram Charan spoke, directors leaned forward in their chairs to capture every word. The sometimes softspoken consultant to CEOs has spent the last 30 years living from a suitcase, on the move from one C-suite appointment to the next.
On this day, he arrived at the Scottsdale meeting from Delhi, eager to share his insights on the oftendelicate, but critical, dynamic between the C-suite and the board. Ever since the passage of Sarbanes-Oxley-mandated director independence, and subsequent court decisions that have underscored directors’ fiduciary duty to represent shareholders in their boardrooms, the balance of power has shifted.
“What is an effective board?” Charan asked. The main task for boards, he said, is not governance but leadership. Charan has a seemingly innate ability to simplify and articulate. To effectively oversee strategy, he advised that the management team, led by the CEO, present the strategy to the board “in less than five written pages.” The language should be clear and concise. There should be no financial statements or external data. The strategy document should be shared with each director and a phone call between the director and the CEO should take place so that the director has the opportunity to ask questions. He suggested that boards, led by the lead director or non-executive chair, work with the CEO to set agendas for 12 months. Peer and board evaluations are musts and can be boiled down by answering three simple questions: Over the last two years, what has been the net output—versus the inputs—of the board? What two things could the board have done better? What two things does the board need to do next year?
Wrap Up: The Big Picture
“It’s a new risk and regulatory world out there,” said Mary Pat McCarthy, executive director of KPMG’s Audit Committee Institute and a vice chair of KPMG LLP. “And it will be a real challenge for audit committees and boards to keep sight of the forest while they’re dealing with all the trees.”
Indeed, echoing Beresford’s concerns about keeping a handle on all the regulations impacting companies, Weil Gotshal attorney Holly J. Gregory reminded the group of three converging trends that should put oversight of corporate compliance high on the agenda: heightened FCPA enforcement, new whistleblower bounties and recent amendments to the Federal Sentencing Guidelines. “Companies should thoroughly reassess their compliance programs and have a robust dialogue with the compliance officer,” the lawyer advised. “Where are the greatest compliance risks? And what is the company doing to set the right tone for ethics and compliance throughout the organization?”
Another macro trend that, for many companies and industries, has arrived already: developments in IT and cloud computing and the risks and opportunities that emerging technologies present. “The proliferation of technologies and data is bringing profound change,” noted Steven Hill, KPMG’s national innovation leader. Citing the increasing virtualization of organizations and mobile workforces and projections that “more data will be produced, managed and analyzed in the next two years than in all of human history,” Hill sees the paradigm shift in IT and information well under way. “Until now, most data has been retrospective. But technology is now turning that on its head as the value of data becomes more prospective,” he said. “It’s important to analyze what happened last quarter, but to see what’s ahead—that is the Holy Grail.”
Four Major Risks to the U.S. Economy – An excerpt from David Hale Global Economics Forecast, Vol. 09.01
Inflation
Higher inflation could depress real income growth and thus constrain the upturn in consumer spending. The Consumer Price Index (CPI) increased by 0.5% during December because of a 4.6% gain in energy prices. The oil price in early January of $91 per barrel is high compared to a fourth quarter average of $85.03 and a 2010 average of $79.43. Food prices also rose at a 1.5% annual rate, which was the second largest increase since June 2009. During the past year, the CPI rose by 1.4% and was led by a 2% gain in commodity prices and a 1.2% gain in service prices. The core CPI excluding food and energy rose by only 0.6%, or the lowest rate of gain in the last 50 years.
In 2011, energy prices could rise another 10% during the first half of the year. The USDA expects food prices to increase 2-3% for the year as a whole. Energy has a 9% weighting in the CPI and food has a 14% weighting. They could produce an annualized inflation rate of 2.8% during the first half of 2011. The Social Security tax cut should boost personal income growth into the 4-5% range during the first quarter, and thus help to compensate for higher inflation.
Weak Housing Sector
The housing sector remains weak because of excess inventory resulting from foreclosures. It could take 11 months to sell the current supply of housing on the market, compared to a long-term average of seven months. There are currently 3.9 million homes for sale compared to a long-term average of 2.5 million. Since 2006, 6.4 million homes have gone through foreclosure while 4.4 million mortgages are currently more than 90 days overdue or in foreclosure.
The U.S. should have a core housing demand of 1.6 million units per annum because of new household formation (1.2 million) and homes being destroyed by fire (400,000). The recession sharply curtailed the rate of household formation. As employment conditions improve, there will be a rebound that could bolster demand for new housing. The recovery will then become self-reinforcing by creating new construction jobs.
State and Local Government Spending
The Center on Budget and Policy Priorities estimates that state deficits will be $122.6 billion during the 2011 fiscal year and could be as high as $112.7 billion in fiscal 2012. The Obama stimulus program has so far provided $140 billion of assistance, but only $60 billion remains to help the states this year and this number will drop to $6 billion in fiscal 2012. The state and local government sector accounts for 19,407,000 jobs, or 14.8% of the total. It could easily lose another 200,000 jobs in 2011.
The municipal bond market has suffered from investor concern about deteriorating credit quality. Yields on 30-year triple A bonds have risen above 5% for the first time since 2009. Municipal bond funds have experienced an outflow of $20 billion over the past 10 weeks. The Vanguard Group has delayed plans to launch three new municipal bond funds.
Federal Fiscal Policy
The newly elected Republican Congressional majority is determined to reduce federal spending. They will attempt to use the pending need to increase the fiscal debt ceiling as a form of leverage for obtaining spending cuts this year and next year. The Republicans now acknowledge that their original target for $100 billion of spending cuts is unrealistic, but they will probably strive for at least $50 billion of spending cuts. They are also talking about $2.5 trillion of cuts in discretionary nondefense spending over 10 years. The markets could be apprehensive about the politics of the debt ceiling increase if the Republicans make promises to reduce discretionary spending.
Participants and Speakers:
Dennis R. Beresford – Director, Fannie Mae, Kimberly-Clark, Legg Mason
H. Raymond Bingham – Director, Dice Holdings, Flextronics International, Oracle, Spansion, STMicroelectronics
William A. Burck – Partner, Weil, Gotshal & Manges
Ram Charan – Business advisor, author and management/leadership expert
Jeffrey M. Cunningham – Managing director and senior advisor, NACD
Tom Duffy – National managing partner, Audit, KPMG LLP
Barry A. Fromberg – Director, Constellation Brands, Xtera Communications
Mary J. Steele Guilfoile – Director, Interpublic Group, Valley National Bancorp
Holly J. Gregory - Partner, Weil, Gotshal & Manges
David Hale – Chairman, David Hale Global Economics
Steven Hill – National innovation leader, KPMG LLP
Irvine O. Hockaday, Jr. – Director, Crown Media Holdings, The Estée Lauder Cos., Ford Motor Co.
Teresa E. Iannaconi – Partner, KPMG’s Department of Professional Practice and former deputy chief accountant, SEC’s Division of Corporation Finance
Jim Liddy – Vice chair, Audit, KPMG LLP
Alex J. Mandl - Director, Dell; chairman, Gemalto and Horizon Lines
Mary Pat McCarthy – Executive director, KPMG Audit Committee Institute and U.S. vice chair, KPMG LLP
J. Thomas Presby – Director, ExamWorks Group, First Solar, Invesco Ltd., Tiffany & Co., World Fuel Services
Donna E. Shalala – President, University of Miami and former U.S. Secretary of Health and Human Services
Adrian Tocklin – Director, Thrivent Financial for Lutherans
Anton R. Valukas – Chairman, Jenner & Block; Court-appointed Examiner, Lehman Brothers Holding Bankruptcy
Bart van Ark – Chief Economist, The Conference Board
Donna Zarcone – Director, Cigna Corp., Jones Apparel Group