Depending on Independence: Fraud and Audit Committees

October 2012

IN THIS ISSUE

— Outside Directors, Insider Trading: The Need for Independence
— Admission Testing: Performing Due Diligence Before Opening the Boardroom Suite

GREETINGS!

Welcome to the October 2012 edition of our newsletter! In this issue, we’ll examine how conflicts of interest among a company’s audit committee members can cause enforcement concerns, look at what the U.S. Securities and exchange Commission is doing about it, and what your clients can do about it as well.

OUTSIDE DIRECTORS, INSIDER TRADING: THE NEED FOR INDEPENDENCE

The recent sentencing of former Goldman Sachs Managing Director Rajat Gupta to two years in federal prison for insider trading made headlines for a variety of reasons, but one of the key elements of the case is somewhat lesser known: Gupta was also a non-executive, or outside, director at several large publicly-traded companies, including Procter & Gamble and American Airlines. While the criminal case against him centered on inside information obtained concerning the investment made by another publicly-traded company, Berkshire Hathaway, in Goldman Sachs, Gupta was also alleged to have tipped Raj Rajartanam of galleon Group off to information gleaned from some of his outside directorship conference calls. Gupta’s place of trust in some of the nation’s most powerful boardrooms afforded him access to executives and information which, if used to influence trading decisions, could reap recipients millions in profits.

Gupta served at various times on the audit committees of Goldman Sachs, American Airlines’ parent holding company AMR Corp. and Procter & Gamble. While the trust placed in all directors and their committee appointments — whether to the compensation or nominating committees, for instance — is essential, the function of the audit committee is critically important in combating fraud and ensuring accuracy in financial statements. In a 2003 rule following the enactment of Sarbanes-Oxley, the SEC said: “Effective oversight of the financial reporting process is fundamental to preserving the integrity of our markets. The board of directors, elected by and accountable to shareholders, is the focal point of the corporate governance system. The audit committee, composed of members of the board of directors, plays a critical role in providing oversight over and serving as a check and balance on a company’s financial reporting system. The audit committee provides independent review and oversight of a company’s financial reporting processes, internal controls and independent auditors. It provides a forum separate from management in which auditors and other interested parties can candidly discuss concerns. ” when that candor is compromised and used for outside material gain, the ability to trust a company’s financial statements is also tarnished.

ADMISSION TESTING: PERFORMING DUE DILIGENCE BEFORE OPENING THE BOARDROOM SUITE

The downside risk of not vetting director candidates (especially on the audit committee, but also elsewhere) becomes obvious in instances like the Gupta matter. But what can corporations do to protect themselves? A thorough investigation of the public record, including any history of regulatory discipline or litigation, should be conducted, followed by efforts at interviewing former colleagues and subordinates to help follow any leads a public records investigation would produce. Federal and state regulatory agencies would also likely provide immensely helpful material via state open records act requests or those made under the federal Freedom of Information Act.

Due diligence is about risk management, not risk abatement. But casting a skeptical eye toward a prospective board member before placing that person in a position of trust and power can pay huge dividends for a corporation’s counsel and executives — as well as providing a sense of stability and security for its customers and shareholders.