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“With all thy governing, get understanding.” More than a dozen public company directors who were convened for the sixth annual Audit Committee Issues Conference echoed the famous proverb, slightly amended for boardroom use, as they shared their experiences in the wake of the economic crisis. While directors expressed their concerns about the immediate and long-term health of the U.S. economy and the prospects for growth, they are equally concerned about the specter of over-regulation. This year’s conference was sponsored by KPMG’s Audit Committee Institute, NACD, Weil Gotshal & Manges and the University of Miami.
Over-regulation, globalization, changing liquidity profiles, financial complexity—these were just a few of the topics discussed at this year’s Audit Committee Issues Conference. “Against the backdrop of a rapidly changing business environment and a still fragile economy, there are a host of challenges and opportunities confronting business leaders,” said Henry Keizer, KPMG’s Global Head of Audit, during opening remarks. “The key will be to understand your changing business fundamentals and to focus on the areas of greatest impact in the months ahead.” Roundtable participants included Fortune 500 public company directors who serve on the boards of such prestigious companies as AIG, AXA Financial, Comcast, ExxonMobil, JPMorgan Chase, Microsoft, Oracle, PetSmart and UnitedHealth. NACD Directorship’s chairman and editorial director, Jeffrey M. Cunningham, moderated the wide ranging and provocative discussion between these veteran directors and governance gurus.
ADDITIONAL COVERAGE FROM THE ISSUES CONFERENCE:
A New Normal in the Boardroom?
The baseline for discussion was set against the question of whether board directors see a return to business as usual or what was referred to as the “new normal.”
“From my experience, I think we’ve learned to imagine the unimaginable,” said Charles H. Noski. “Just consider that several institutions that were around for a century or more don’t exist any longer. In boardrooms today, the talk is routinely about the new normal, which simply means we are still in an economic recession that has occurred globally and broadly, so yes, there is a new normal.”
Another theme repeatedly echoed was the nature of changing business models and not only for financial services, where impending legislation could still rewrite the rules for large banks, insurance companies and private equity. Michele J. Hooper said that while the economic crisis accelerated restructurings at some businesses, others face different but equally daunting challenges. “For pharma companies, there is the constant of pricing pressures, the challenge to develop patents, the time and cost to develop new drugs, changes to sales and marketing models…[these] are global issues for the industry,” Hooper said. “As healthcare budgets are challenged around the world, the pressure on exactly who is going to pay for new drug therapy development is a critical question. The new normal is that change is a constant.”
Even as the worst of the economic storm seems to be receding, populist fervor against big business, the financial sector and Wall Street continues unabated. Directors find that amid competing and sometimes conflicting legislative and regulatory proposals, it’s difficult to even guess which regulatory approach will prevail. Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware, noted, “There are two problems. First on a macro governmental level, I think we’ve seen an extraordinary shift in the way in which the government interacts with the private economy. On a secondary level for directors, I think we’re seeing a real change in how boards work. But there’s a danger that the regulatory restrictions and demands are forcing boards to make decisions that are not their own.” Added Christopher S. Lynch, “In this politically charged and economically uncertain environment, the challenge for boards of the GSEs (government-sponsored enterprise) is to provide management some contextual perspective on how the business model might evolve.”
Even so, there appears to be new or renewed commitment to growth, which was quite refreshing to hear and led to a discussion of how CEOs are preparing a new set of objectives and a related set of investments to achieve them. For the CEO, that means priorities may have changed. “After finding sufficient liquidity to pay our dividends, I think now the question is, ‘How do we get back on the path to growth?’” said Alex J. Mandl. “Cost-cutting can only take you so far. What kinds of acquisitions, what kinds of investments need to be made—whether it’s in people or systems. Those are the critical questions facing companies today.”
Specter of Overregulation
In addition to complying with new rules and regulations, several audit committee members sounded the alarm on what they fear may be extreme regulation.
“Frankly, I’m very concerned about the role of government, the risk of overregulation and the possibility of being overly burdened by public policy,” said Reatha Clark King. “I don’t hear enough debate about it among directors and I’m very concerned about more government involvement and its impact on the competitiveness of our companies.”
Directors echoed King’s concerns, noting that while boards have gotten beyond the initial onslaught of new compliance activity as the result of the SOX, “the government has an infinite capacity to create new programs, so you have to constantly step it up. The issue for directors today is, ‘What is our business model and what are we going to do to compete?’” said Richard K. Lochridge.
Regulation needs to be properly balanced between the call for greater transparency and measures that would appear to add little value economically. “Business remains uncertain as to the intent of the increased governmental regulation,” said Kathleen Connell. “Is it transparency and accountability for investors, improved risk management to prevent future systemic failures or simply political optics and burdensome reporting? Properly conceived systemic risk-management policies and increased transparency and accountability practices add value to the corporate community, increasing their competitiveness by restoring consumer confidence and assuring investors that businesses are well managed.”
Financial Communications
Earnings guidance would alone be a subject for a lively and divergent discussion. If the company on whose board you serve didn’t stop or change the way it issued earnings guidance, you were in a minority. One exception may apply to technology-oriented companies, however, because the market’s expectations are different. “In the tech world, where there’s still an expectation of growth by investors, there’s a stronger inclination to give some sort of guidance,” said Ray Bingham. “The metrics used have changed over time and certainly, the tolerances accepted around any particular set of numbers have gotten much, much wider as the perception of risk has grown.”
The assembled directors also agreed that their audit committees are more deeply scrutinizing all of the company’s financial communications. In the view of one director, the earnings press release is the most important communication to investors, but there was also discussion about how to manage the volume and complexity of financial and other information that boards receive.
“We’ve set up a series of informal audit committee calls throughout the quarter in which directors can participate with management and our outside advisors to learn more about emerging issues, key assumptions, accounting and financial-reporting alternatives and potential outcomes,” Lynch said. “We’ve requested that management spend more time with our directors to ensure we better understand the complexity of the issues they are dealing with and how those transactions will be presented in our public filings.”
Mary R. “Nina” Henderson suggests receiving financials and the MD&A separately, one in advance of the other. “This permits a deeper dive and fuller review,” she said. “Also, any matter with continuous impact, based on numerous estimates and assumptions, is reviewed frequently, not only at Q and K review meetings.”
The Securities and Exchange Commission has emphasized disclosures and the MD&A in its new rule-making. “This focus on disclosures is likely to continue and will probably increase—particularly with the SEC’s new disclosure rules regarding compensation, risk and governance,” said Teresa E. Iannaconi. “The SEC is very focused on the protection of investors, but they may miss the forest for the trees,” said Holly J. Gregory. “There seems to be little concern about the impact of their regulatory efforts on how boards function. The perspective I’ve heard expressed by SEC staff in discussions about proxy access is ‘Our role isn’t to think about what the impact might be on the boardroom and the corporation. We are here to protect investors.’ But I think it’s reasonable to ask, to what end?”
Added Gregory, “Investors need corporations capable of succeeding over the long term and this requires regulations that are thoughtfully balanced.”
The Business of Risk
The NACD’s Kenneth Daly said what most audit committee members know all too well: the time commitment to public company board service is “nothing short of unbelievable.” But it’s not the amount of time spent on board work that’s the issue, noted J. Michael Cook, it’s how directors are being asked to use their time. “I know lots of folks who will spend the time—have another meeting, stay longer—if they feel they are adding value and doing something important. What’s frustrating to many people is the amount of time we spend doing things that aren’t very productive…And then, after we do all this great work on risk and risk management, identifying and dealing with the critical risks affecting the business, perhaps the greatest risk—the financial viability of our economy and the financial future of our country—is outside of our control and is being decided for us by people who often are not fiscally responsible in the costs and risks they impose on us.”
Cook raised a point central to any current assessment of the audit committee. With the tremendous focus on risk, there was general agreement that the full board should oversee the strategic risks facing the company. “We see the audit committee’s responsibility for risk often narrowing to risks within the audit committee’s core areas of oversight—clearly financial reporting risks, but also compliance risks, perhaps IT risk, sometimes financial risks,” Mary Pat McCarthy said. “If the board doesn’t have a finance committee, the audit committee may take on that issue as well.”
Cook, who described himself as a “fairly strict constructionist,” said he doesn’t believe committees should be doing work that belongs on the agenda of the full board: “The audit committee exists to oversee one very specific enterprise wide risk and that is the risk of erroneous or fraudulent financial reporting.”
Viewed from a different angle, Bingham suggested that strategy should not be formulated for the avoidance of risk. “In my view it should not be so much the avoidance of risk but rather the requirement that the board understand what kind of risk the company is exposed to and whether there will be an appropriate payback for the risk that’s being tolerated,” he said.
Improving Governance
While criticism of corporate boards has never been more acute, more than half of the audit committee members attending the Issues Conference said the public’s criticism was justified. What measures should be taken to improve board performance? Prepping directors for new roles within the boardroom, evaluating their performance, managing information and ensuring commitment and engagement of individual directors spurred the most comment.
Clearly, there’s no one single rule that applies to all companies; there are various ways to approach both the orientation of new directors and their ongoing contributions as effective board members.
“I know of no highly effective business organizations that don’t evaluate individual performance,” Lynch said. The most effective evaluations, according to Mandl, are led by the independent chairman or lead director or “someone who has the capacity to talk to individuals and as a whole to take the lead.”
Bingham serves on a European board that retains an “expert” to support the board and each committee. The job of these experts is to review management’s reports analytically and assist the board and committees with their work. They are hired externally and supervised by the board.
Greatest Concerns
At the conclusion of each Roundtable—one was held in Miami, the other in Phoenix—directors were asked to rank their concerns. Interestingly, the growing threat of reputation risk, including risk related to enforcement under the Foreign Corrupt Practices Act, generated reaction at both sessions and led to some agreement that “tone at the top” is—or should be—a major area of focus for directors. Bruce Piller of KPMG concurred. “To me, tone at the top is a risk that carries over to a number of areas on the audit committee’s plate—from financial-reporting risk, to the control environment, to fraud risk and compliance.” Reputation risk, said Laban P. Jackson, “is what we worry about all the time. And the thing that I worry about is that our people know that the board cares about how they perform ethically. It is incredibly important to me to get out and meet the people out there and let them know that I care about the work they’re doing.”
The challenge is to communicate tone at the top “deep, deep into worldwide organizations,” said Ellen Odoner. “One key source of support and vigilance can be the legal department. In the United States, reinforced by SOX, inside lawyers recognize that they are expected to play an active compliance as well as business role. It is vital to build the same understanding among the lawyers in far-flung business units.”
Keizer offered a final thought on what should top the agenda of boards and audit committees going forward, echoing the sentiments of directors: “The one key challenge is tone at the top and culture within the organization. Who are we and what do we want to be known for? What’s being measured? What is management being rewarded for? When it comes to culture and tone at the top, we need to make sure that we have learned from the crisis and that we reward the right behavior. That, to me, is the overarching issue.”
Conference Speakers, Panelists and Thought Leaders
Ray Bingham – Director, Dice Holdings, Flextronics International, Oracle, STMicroelectronics
Kathleen Connell - Chair, Corporate Governance Center, Berkeley Haas Graduate School of Business
J. Michael Cook – Director, Comcast, International Flavors and Fragrances
Jeffrey M. Cunningham - Chairman, CEO, Editorial Director, Directorship
Kenneth Daly – President and CEO NACD
Charles M. Elson – Weinberg Center for Corporate Governance, Director, HealthSouth
Holly J. Gregory – Partner, Corporate Governance, Weil, Gotshal & Manges LLP
Mary R. (Nina) Henderson – Director, AXA Financial, Del Monte Foods, Pactiv
Michele J. Hooper – Director, AstraZeneca, PPG Industries, UnitedHealth Group, Warner Music
Teresa E. Iannaconi - Partner, National Office, KPMG LLP
Laban P. Jackson – Director, JPMorgan Chase
Henry R. Keizer – Global Head of Audit, KPMG International Cooperative, and U.S. Vice Chair – Audit, KPMG LLP
Reatha Clark King – Director, ExxonMobil
Richard K. Lochridge – Director, Dover Corp., Lowe’s, PetSmart
Christopher S. Lynch – Director, AIG, Freddie Mac
Alex J. Mandl – Director, Dell, Hewitt Associates, Horizon Lines, Visteon; chairman of the board, Gemalto
Mary Pat McCarthy - U.S. Vice Chair, KPMG LLP, and Executive Director, KPMG’s Audit Committee Institute
Charles H. Noski – Director, ADP, Air Products & Chemicals, Microsoft, Morgan Stanley
Ellen J. Odoner – Head of Public Company Advisory Group, Weil, Gotshal & Manges LLP
Bruce J. Piller – Western Regional Managing Partner, KPMG LLP