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Held June 9-10, 2003 at The Ritz-Carlton, Tysons Corner in Washington, D.C. Co-Chair Mark Terrell, Executive Director of KPMG’s Audit Committee Institute, opened the proceedings, noting that each year, CPE INC.’s corporate governance conference either breaks news or begins high-level debate on the very latest events in the world of corporate governance. LEGAL & REGULATORY UPDATE John Huber, former head of the Corporate Division of the SEC, began session one with commentary on the June 6th release of the SEC’s final rule, Management’s Reports on Internal Control over Financial Reporting & Certification of Disclosure in Exchange Act Periodic Reports. In recognition of the difficulties public companies face in preparing to satisfy the requirements of Sarbanes-Oxley, the rule provides more time to put necessary procedures in place. For example, it eases the Section 404 regulation that the 10K include a management report on the company’s internal controls over financial reporting by requiring a full evaluation at year-end but not each quarter. Instead, the quarterly report need only evaluate any change that has materially affected or is likely to materially affect the company’s control over financial reporting. The document also provides some flexibility for companies to set their own distinctions between disclosure controls and internal controls. Huber commented that HealthSouth will be the big test case in determining how Section 404 may define misconduct with respect to misstatements under Section 906. Daniel Goelzer, founding member of the Public Company Accounting Oversight Board and former General Counsel to the SEC, indicated that the PCAOB is gearing up to take over inspections from the SEC and AICPA, set auditing standards for the conduct and procedures of auditing firms when auditing public companies and enforce the practice of the SEC’s rules and standards. Once registered, auditors will be inspected regularly to assess compliance with PCAOB and SEC rules and quality control systems. Deficiencies will be identified and a report issued, after which the firm will have 12 months to bring itself into compliance. Katie Martin, Partner at Wilson Sonsini Goodrich & Rosati, shed light on additional Sarbanes-Oxley rules, including the requirement that historical financial information be disclosed in the 8K, the addition to the audit committee of a financial expert, the new attorney conduct “whistleblower” rules and the requirement that public disclosures using non-GAAP financial measures must be accompanied by the most directly comparable GAAP measure and the differences be reconciled. John Olson, Partner at Gibson Dunn & Crutcher, addressed assessment of director independence. The focus will be on how the audit committee deals with interim financial information, as well as the presence of a financial expert, procedures for internal controls and disclosure controls and procedures, and disclosure of nonaudit services. Hot buttons in the press will continue to be CEO and senior officer compensation, as well as the director selection and nomination process. WHO’S MEASURING CORPORATE GOVERNANCE? Peter Clapman, Senior Vice President and Chief Counsel, Investments, at TIAA-CREF, opened the session by noting the impact of institutional investors on corporate governance. As seen in the last proxy season, investors are increasingly active in making their opinions known on issues such as director independence and executive compensation. Patrick McGurn, Senior Vice President & Special Counsel at Institutional Shareholder Services, elaborated on the sea change in investor attitudes during the last proxy season, which saw more than 1,000 shareholder proposals on corporate governance. Hot button issues included audit fees, audit firm rotation and boardroom reforms including fully independent audit compensation and nominating/governing committees. The push toward valid access – federal proxy rules for gaining shareholder access to the director nominating process – is such that the SEC will consider the issue in mid-July. Howard Sherman, CEO of GovernanceMetrics International, spoke of corporate governance as an insurance policy to protect the value of shareholder assets. Credit rating agencies and D&O insurance underwriters are factoring in governance issues in light of the growing body of evidence that the link between performance and governance is statistically valid. Bad corporate governance is seen as a market risk, and companies that acquire a reputation of unresponsiveness in this area will see the value of their stock affected. D&O INSURANCE Lisa Klein Wager, Partner at Morgan Lewis, stated that filings and private actions were up last year for the first time since 1998. Twenty percent of companies with market capital of over $10 billion were sued in 2002 and $2.4 billion in settlements paid out. The greater risk of litigation means increased responsibilities for outside directors, who face rising premiums, more exposure to greater losses and potentially less coverage. Lisa Butera, Senior Vice President of the National Union Fire Insurance Company, asserted that as D&O insurance becomes less profitable, many companies are exiting the business. Among the governance issues assessed by D&O issuers are whether a company has good financial controls in place, its operating risk and management compliance. They also look at the audit committee’s performance: are the members engaged? Do they ask management tough questions? How often do they meet, and how far in advance do they receive their review package? She noted a shift from protecting an organization to protecting individuals, with more severabililty for fraud exclusions. Denise Amantea, Senior Vice President, D&O, at Woodruff-Sawyer, spoke of the growing tension between companies and outside board members, as the outside members seek greater coverage due to the increased risk of litigation and higher settlements. Dana Kopper, Senior Vice President with Lockton Insurance Brokers, Inc., and the Western Region Director of Lockton Financial Services, explained that in certifying CEOs and CFOs, the single biggest weakness found by underwriters is an underestimation of their heightened duties of oversight. Though the ratings industry is new and produces conflicting results, there is a correlation between returns and shareholder rights. He concluded that it is essential that the company convince the underwriters that its infrastructure is strong and manifests transparency, independence and accountability. LUNCHEON PRESENTATION: THE MIND OF THE BOARDROOM Kerry Sulkowicz, MD, Founder & President of the Boswell Group, is a psychoanalyst who consults with boards and managements. Having analyzed boards’ response to their increased responsibilities under Sarbanes-Oxley, he feels that the most common hindrance to their effectiveness is a failure to engage in the most difficult conversations. If the chairman is controlling and intolerant of dissent, if he or she adheres to a tightly scripted agenda and formal presentations with little discussion, the board will tend toward passive acceptance of his or her initiatives and steer clear of open and critical debate. Among other problems encountered are a greater difficulty finding people willing to serve on boards, and a tendency toward infrequent meetings. He proposes that boards establish a process committee to monitor boardroom discussion and regularly assess its effectiveness. Boards must be open to feedback, trained in group dynamics and capable of bridging the gap with management. BUILDING AN EFFECTIVE BOARD James Brady, Managing Director – Mid-Atlantic, Ballantrae International, introduced the session by asserting that the boardroom is in a brighter spotlight than at any other time in its history. Nate Cartmell, Partner at Pillsbury Winthrop, discussed evolving best practices, commenting that current and pending legislation will impose them on boards that do not institute them first. First priority should be adherence to independence requirements. Regularly scheduled executive sessions will be mandated. Effective mechanisms to evaluate performance must be performed at least annually. Herbert Denton, President of Providence Capital, spoke of future trends for boards, above all the increasing influence of institutional investors rather than an all-powerful CEO. Where management is in conflict with shareholders, boards will change. A highly significant recent ruling occurred on May 28, when Delaware’s Chancery Court held that the shareholder suit against the Disney board of directors could proceed and that the directors may be held personally liable despite indemnification for knowing or intentional lack of due care. The implication of this ruling is that directors must be proactive in obtaining from management all the information needed to satisfy the due care requirement. AUDIT COMMITTEE PANEL Mark Terrell, Conference Co-Chair and Executive Director of KPMG's Audit Committee Institute, opened the session by referring to SEC Chairman Atkins’ recent speech, in which he mentioned the unintended consequences of Sarbanes-Oxley – might its expectations dissuade qualified individuals from serving on audit committees? Michael Young, Senior Litigation Partner at Willkie Farr & Gallagher, answered that yes, along with the rising trend of D&O insurance policy rescission, the current regulatory climate has indeed raised the risk of serving on an audit committee. Jim Brady, Managing Director – Mid-Atlantic, Ballantrae International, added that audit committee participation also is more enjoyable than ever before, as it has come to be highly regarded by management as a risk mitigant. Addressing the issue of overstepping the line between oversight and management, he noted that the committee’s job is to understand the risk environment and put in place mitigation processes to ensure that these risks are dealt with appropriately from the financial reporting standpoint. The audit committee is increasingly being seen as an all-purpose problem anticipator and solver, and this broadening of responsibility can get in the way of its primary function of assessing and monitoring the tone at the top, ensuring that the right environment is established and maintained and obtaining knowledge of any wrongdoing. Scott Reed, Partner, KPMG Audit Committee Institute, noted that it was crucial for the committee to set its own agenda by controlling the flow of information it receives. External auditors have become a crucial source as a result of Sarbanes-Oxley’s clarification that they are accountable to the audit committee, independent of management. Jim Brady added that internal auditors also can be an invaluable tool that should be strengthened and accountable to the audit committee. Michael Young stated that we are in the midst of a cultural transformation from worshipping analysts’ expectations to holding in highest regard a company’s transparency in financial reporting, and that the audit committee has been asked to lead this transformation. Mark Terrell concluded that the audit committee should never lose sight of the fact that the company is but a byproduct of its core responsibility to represent the shareholders. HOW ARE EFFECTIVE BOARDS OPERATING? Moderator David Berger, Partner at Wilson Sonsini, opined that the Delaware chancery court may have gone too far recently in stating that board members should not be too friendly with other directors because it would inhibit their ability to confront them if necessary. He posited that such advice would lead to isolated individuals at the expense of collegiality. Robert Lamm, Corporate Secretary and Director of Corporate Governance for Computer Associates International, noted that the proper function of the board is oversight, as opposed to its public perception as guarantor of correct corporate behavior. He sees tremendous pressure on boards to prevent companies from engaging in financial scandal or restatement and effectively to supplant rather than monitor management. He defines oversight as the proper mix of support, skepticism and disinterested objectivity, a step beyond mere independence. Board members must be able to ask the tough questions and persist in getting them answered. They must receive the proper materials at the right time. In addition to naming a financial expert, the entire board should take the time and effort to know the company and its business and feel able to express individual views and provide CEO guidance. Sarbanes-Oxley supports the use of outside advisors, and the NYSE proposes instituting an obligatory executive session, in which the board meets without the CEO. It is vital that the board trust management and that the CEO be receptive to candid discussion and frank recommendations. Eugene Fife, Founding Principal of Vawter Capital and former Chairman of Goldman Sachs International in London, placed the highest priority on involvement – members should enjoy active participation and understand the company’s core business. Long-standing board members should evaluate management and manage and control compensation issues based on a thorough understanding of the company’s performance. In setting standards for behavior, the board should be wary of overstepping the line between oversight and micromanagement and at the same time be prepared to step in if behavior is unacceptable. Also crucial is to listen to company shareholders, particularly regarding executive compensation issues. He cited the new Delaware court ruling that Disney’s board of directors can be held personally liable for its compensation decisions. He concluded that corporate power today has shifted from management to the boardroom, to the shareholders’ benefit, and that the best way to handle the increased attention and responsibility is for board members to do their homework, go with their gut, speak up early and often and set the agenda. HOW TO DETECT, DETER & DEAL WITH CORPORATE WRONGDOING John Pritchard, Partner and Vice Chair of Pillsbury Winthrop, spoke of a boomlet of corporate wrongdoing, particularly in the area of accounting fraud. To conduct a proper internal investigation, the board must take the initiative. By discovering the facts, it puts itself in a strong position to take action. It can fire or discipline, bring suits and send the message that wrongdoing will not be tolerated. This will, in turn, prepare the company to deal effectively with investigation by the SEC or Justice Department. By mastering the facts, the board can shape the investigation and point the finger correctly at the individuals to blame, thus limiting the consequences to the company as a whole. Lanny Davis, Partner at Patton Boggs and former Special Counsel to President Clinton, addressed the use of public relations as a legal and business strategy to mitigate damages. Full disclosure creates a bounceback effect, and public media affects the outcome in courtrooms. Critical to lawyers is avoiding unintentional waivers of privilege, which can lead to their becoming fact witnesses. Lawyers should assume that whatever they say to a public relations firm will become subject to deposition questioning. Jeffrey Rudman, Senior Partner at Hale and Dorr, noted today’s culture of righteousness, a reaction to the previous one of excess. He stressed the importance of preserving a sense of proportion and judiciousness. When beginning an investigation, for greatest credibility, a new outside accounting firm should be engaged. The lawyer should present all information early and straightforwardly, while serving as the board’s advocate by concentrating on investigation of facts that are material, can be proven and will lead to minimal damages. David Brodsky, Partner at Latham & Watkins, opined that the current batch of corporate wrongdoing is but the tip of an iceberg, as corporate America is turned upside-down by new rules, new interpretations and new behavior on the part of the SEC, outside auditors and counsel. The attorney’s focus should be to limit shareholder suit damages, but first to avoid indictment or charges against the company. If wrongdoing is discovered, the audit committee should retain independent counsel, which presents a strong picture of cooperation and credibility if a governmental investigation follows. Critical to cooperation according to the SEC and Justice Department guidelines is nonassertion of attorney/client or other privilege. If possible, the company should turn itself in in a jurisdiction that will consider a selective waiver or to the SEC’s DC office, which is trending toward granting selective confidentiality agreements. The Justice Department has stated that timely, voluntary disclosure is crucial and that the investigation cannot be obstructed or impeded. Because the goal is real-time enforcement, the company’s internal investigation will run in tandem with the governmental one. The attorney should go immediately to the regulators and bring in a panel of outside lawyers with no other connection to the company. Proactively, the board should have in place an effective compliance program that states the company’s policies and procedures and features a training program, followed up by a strong internal audit function. The audit committee is responsible for the compliance program and should assume a counseling function with the committees and outside directors. LITIGATION & SHAREHOLDER ACTIONS Michael Perino, Associate Professor at St. John’s University School of Law, noted that regulators’ focus in the late ‘90s was on preventing abuses in securities class action litigation by implementing, among other measures, a higher pleading standard. However, the frequency of litigation subsequently increased. The difference seems to be due to stronger cases of accounting violations and insider trading. Additionally, post-Enron, the courts began backing away from a strict interpretation of the pleading standards. Patrick Daniels, Partner at Milberg Weiss Bershal Hynes & Lerach, addressed institutional investor concerns, stating that changes in corporate governance, such as the lead plaintiff provision, have taken control away from individual investors in favor of larger institutions. As these investors saw their losses rise, they became increasingly aggressive and likely to litigate and agitate for individual accountability. Proxy initiatives will continue, but class actions are increasingly regarded as the vehicle to obtain changes, such as the ability to appoint a lead director, the independent ability to hire outside lawyers and accountants and a mandatory 5-year rotation of audit firms. David Clarke, Partner at Piper Rudnick, noted that the trend in litigation is toward an expansion of controlling person liability. As adopted by Judge Harmon in the Enron proceedings in Houston last December and supported by the SEC, if a company issues a material misstatement or omission, an executive deemed a controlling person can be sued as a direct violator of the statute, even if he or she has not signed the document or identified him- or herself to investors. Laurie Smilan, Conference Co-Chair and Partner at Wilson Sonsini, confirmed that the courts are tending to give plaintiffs more benefit of the doubt by more loosely applying the pleading standards. As shown in the AmericaWest case, which she deemed an “earth-shattering capitulation of the defense in securities litigation,” secondary actors such as officers, outside directors and shareholders can be held accountable for having knowledge of false statements. John Millian, Partner at Gibson, Dunn & Crutcher, agreed that such cases have raised the bar for the standard of care, particularly for outside directors. In effect, corporate governance best practices have now become requirements, and new duties will continue to be created under state and federal law. This climate may affect director and officer indemnification as liability is extended to noncertified persons, particularly the designated financial expert, who will be the most likely target of exchange act or derivative claims. Attorneys also could be subject to derivative claims under the controversial whistleblower provisions. |
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