Audit Committee Independence: The Importance of Researching Conflicts Among Board Members
September 2011
IN THIS ISSUE
— “Financial Experts” and Their Conflicts: the Role of the Audit Committee
— Sarbanes-Oxley, Reform Attempts and the Need for Vigilance
GREETINGS!
Welcome to the September edition of our newsletter! In this issue, we’ll examine the importance of vetting a publicly traded company’s board of directors, particularly audit committee members, before making a significant investment, partnership, or other transaction.
“FINANCIAL EXPERTS” AND THEIR CONFLICTS: THE ROLE OF THE AUDIT COMMITTEE
Every publicly traded company is supposed to, and typically does, rely on its board of directors for overall strategic guidance, insight into market trends, and the other “big picture” advice needed to run a large organization. While most boards have committees to advise on compensation issues and corporate governance, one of the most critical functions of a board of directors is that performed by the audit committee: to ensure the financial statements issued to the investment community.
The problems caused by flawed audit committees within the last decade are well known: the board of directors at Enron Corp., for instance, in 2000 was ranked among the top five firms in the country by Chief Executive magazine for having one of the most competent and informed boards .
The board, which featured former U.S. Commodities and Futures Trading Commission Chair Wendy Gramm (wife of former U.S. Sen. Phil Gramm, R-Texas) and former Stanford Business School Dean Robert Jaedicke, had considerable expertise — but also was rife with conflicts of interest that called into question its ability to serve the Enron’s shareholders: Mrs. Gramm, for instance, was also affiliated with a George Mason University center that received approximately $50,000 in donations fro Enron in the years preceding the firm’s collapse. John Mendelsohn, another audit committee member, was employed by the M.D. Anderson Cancer Center at the University of Texas, which received millions in donations from Enron and its founding chairman, Kenneth Lay.
SARBANES-OXLEY, REFORM ATTEMPTS AND THE NEED FOR VIGILANCE
While Enron and other large corporate financial statement frauds (Adelphia Communications and MCI WorldCom being near the top of a rather long list) ushered in the 2002 Sarbanes-Oxley Act and subsequent reforms meant to curtail self-dealing and obfuscation of a company’s true financial position, the reforms only went so far. The bill mandated that at least one strictly defined “financial expert” serve as an independent member of each audit committee, and many non-profit entities found even this requirement to be onerous. Other rules in the 2002 bill prohibited most personal loans made to executives by the company, as well as disclosure of any contracts held, for instance, between a publicly-traded company and a service provider owned by an audit committee member that provided a service to the company, such as a charter jet rental.
In the time since these reforms were enacted, greater transparency has occurred with respect to contracts like the example above. But connectivity between parties is often more subtle and insidious, whether via fund-raising for a shared alma mater or service on a non-profit company’s board of directors (which is not explicitly stated as required for disclosure under Sarbanes-Oxley.) If such linkages become public and cast doubt in the minds of shareholders or the public as to the true intent of a company’s audit committee, charged with ensuring the accuracy of that company’s financial statements, the public relations and investment consequences can be dire. Before considering a high-profile venture or investment in a publicly-traded company, the research efforts of a fraud examiner skilled in identifying the opaque relationships which exist outside public vie — and are often all the more relevant because of their secrecy — can be a very worthwhile measure to make sure the company you’re dealing with is dealing fairly.