Corporate Governance Observations and Recent Trends

Robert H. Moone, Chairman, CEO and President, State Auto Financial Corporation
David Lehman, President Mennonite Mutual
John P. Beavers, Chair of the Corporate Department, Bricker & Eckler LLP
December 2003

Enron, Tyco, Imclone, Dynergy, Adelphia and WorldCom have shaken investor confidence in corporate America. The focus of Congress, the SEC, the stock exchanges, institutional investors, rating agencies, large creditors, and even unions is independent oversight of management. All view that the best line of defense against corruption is a combination of independent directors with an independent external auditor and a competent internal auditor that report to those independent directors, with each freely communicating with the other. Regulators of regulated industries such as banking and insurance now have the same focus. The purpose of this article is to share (i) observations of what financial services industry regulators are doing and (ii) trends form recent surveys on board governance in a post-SOX (Sarbanes-Oxley) environment.

Observations of what regulators are doing

From the view point of our practice of law, financial services industry regulators are increasingly treating governance as the “foundation of the safe and sound operation” of a financial service company. Although mutual insurance companies are not subject to SOX or the SEC, NYSE, Nasdaq or Public Company Accounting Oversight Board (PCAOB) rules thereunder, insurance regulators are likely to recommend that all companies, not just those subject to SOX, adopt some of the corporate governance practices resulting from SOX to the extent feasible given each company’s size, complexity, and risk profile, just as banking regulators have.¹ Below are some observations of the corporate governance practices that we see as the current focus of regulators:

1. Board composition. In addition to the independence required by SOX for audit committee members and by NYSE and Nasdaq for a majority of board members as well as for compensation and nominating/governance committee members, regulators are increasingly taking the position that sound corporate practice requires boards to review the particular knowledge and experience that each independent director candidate brings to the company as a whole. We have heard regulators say that boards need to have the knowledge and experience to understand not only the company’s business, but, more particularly for the financial services industry, the company’s products. In addition, regulators are increasingly inquiring whether a board has sufficient independent directors with financial knowledge and experience to serve as an audit committee; with compensation knowledge and experience to serve as a compensation committee; and governance knowledge and experience to serve as a nominating/governance committee.
   
2. Independence among boards of affiliates. In addition to the SOX, NYSE and Nasdaq definitions of independence from management, regulators are increasingly taking the position that sound corporate governance requires independence of at least some of the independent directors from affiliated companies. For example, regulators believe sound corporate practice requires that the boards of a parent and of a subsidiary consist of independent directors who are not on the board of the other. When two or more entities having common directors on their boards are parties to, or otherwise have interests in, the same transaction, regulators are increasingly examining minutes of board proceedings to determine whether these transactions were considered separately by the non-common directors.
   
3. Independent oversight of the amount and incentives of compensation. Regulators are increasingly taking the position that sound corporate practice requires independent oversight of the amount and incentives of executive compensation. Regulators appear keenly aware that the courts are finding that abusive compensation practices with misplaced incentives were the major contributing factors to fraud at Enron and WorldCom. We can assume regulators are also keenly aware of the SEC’s public questioning of the oversight of the amount and incentives of the compensation to which the boards of the NYSE and General Electric either agreed or acquiesced.
   
4. Internal controls and the internal audit function. More and more, regulators are taking the position that all companies need to have internal controls comparable to those required of public reporting companies and, if the company is of a sufficient size or complexity, all companies need to have an internal audit function. Regulators are increasingly examining whether these internal controls are being periodically evaluated and tested under the oversight of the company’s board or audit committee.
   
5. Oversight of the audit process. Regulators are increasingly taking the position that sound corporate practice requires oversight of the audit process of any company, whether or not subject to SOX, by the independent directors of the company’s governing board or an audit committee of independent directors of the board. Regulators are examining the extent that the board or audit committee have, and actually exercise, authority for hiring, firing, and determining the compensation and scope of both audit and non-audit work of the external auditor as well as for their authority for overseeing that internal controls are effected. Regulators are encouraging boards of companies not otherwise required to do so to establish an audit committee consisting entirely of independent directors and are examining engagement letters with external auditors to determine whether the auditor reports to the board or audit committee rather than to management.
   
6. Elimination of non-audit services by the external auditor. To provide confidence in the financial statements of any regulated company, regulators are taking the position that sound corporate practice requires that all companies, whether or not subject to SOX, are to have an audit report by an external auditor independent of any interest in providing services to the organization other than audit and tax services.
   
7. Continuing board education. Because financial products and services being offered by the financial services industry are increasingly more complex, regulators are taking the position that sound corporate practice requires companies to educate the board on these products. In addition, regulators believe that sound corporate practice requires companies to periodically refresh boards on: 

• Basic fiduciary duties;
• Advanced fiduciary duties, such as during a merger or acquisition; 
• The functions of the board and the functions of management; 
• The board’s role in regulatory relationships; 
• Applicability of various consumer laws; 
• Applicability of various securities laws; 
• Prohibition or policies regarding insider loans; 
• Overview of related party transactions; and
• The board’s and auditor’s role in compliance.

8. Accounting issues. Regulators are strongly encouraging companies to make all material correcting adjustments identified by external auditors regardless of the type of external auditing program the company has implemented and to disclose material off-balance sheet transactions to ensure that examiners and other users of the financial statements are aware of them and can include them in their evaluation of the company's condition and risk profile.
   
9. Conflicts of interest. More and more, regulators are taking the position that sound corporate practice requires knowledge by the board and management of potential conflicts of interest. Regulators are examining codes of conduct or policies to determine if they require a company’s directors and officers to disclose all potential conflicts of interest, including those in which they have been inadvertently placed due to either business or personal relationships with customers, suppliers, business associates, or competitors of the bank. They are also examining whether such relations are, as a matter of course, being disclosed.

Trends from recent surveys

Buck Consultants, a human resources consulting firm based in New York, released a Board of Directors Survey in June 2003. We can observe the following trends when comparing the Buck Survey with surveys conducted by Executive Compensation Advisory Services in 2002 and 2001 and by Acredula in 2000.

Board Composition

Management versus non-management members

The Buck Survey shows a continuing decrease, albeit at a lesser rate than from prior surveys, in the number of management or “inside” directors as boards add directors to meet the independence requirements for audit and the other oversight committees.

Average age of directors

As reported in the Buck Survey, the age of directors is not significantly different from prior surveys.

Types of expertise represented on boards

Although CEOs of other companies remain the principal expertise represented by board members (which was a trend through the 1990s), the Buck Survey shows a trend beginning in the 2000s to broaden the expertise present on boards.

Academicians, consultants and investment technology executives have increased, while retired company executives, investment bankers and commercial bankers have decreased when compared to prior surveys.

Financial reporting experience

The percent of board members with financial reporting experience is increasing and will likely continue to do so as boards find members to meet the requirements for their audit and compensation committees.

Board members whose employers do business with the company

The percent of board members whose employers (or former employers) do business with the company is as follows:

The percentage of board members whose employers do business with the company is decreasing, albeit slowly.

Staggered board terms

Substantially all boards have staggered terms despite concerns of regulators and investors to the contrary.

Board proceedings

Number of board meetings

The Buck Survey shows a continuing increase in the number of board meetings from prior surveys.

Length of board meetings

The Buck Survey shows a continuing trend toward longer board meetings when compared to prior surveys.

Boards meeting regularly without management

Although we do not have comparable prior data, over half of the surveyed companies’ boards meet regularly without management according to the Buck Survey.

Types of board committees

The Buck Survey shows a continuing increase in audit, compensation and nominating/governance committees, and a decrease in executive committees from prior surveys.

 Number of committee meetings

The Buck Survey shows a continuing increase in the number of audit, compensation and nominating/governance committee meetings, and a decrease in executive committee meetings from prior surveys.

Board evaluations

The Buck Surveys shows an increase in the number of boards evaluating themselves annually, but a vast majority of boards do no such evaluations.

Of those boards that perform an evaluation, the following shows the type of evaluation:

Of those boards that perform an evaluation, the following shows the criteria used:

Recent and anticipated changes

Recent changes as a result of SOX and increased focus on governance

Although we do not have comparable prior data, the Buck Survey shows the following changes have been made during the past years by boards of the surveyed companies:

Anticipated changes as a result of SOX and governance

Although again we do not have comparable prior data, the Buck Survey shows the following changes are anticipated during the ensuing year by boards of surveyed companies:

Conclusion

Neither Congress nor regulators can mandate honesty and ethics with legislation and rules. As said by Alan Greenspan, “rules cannot substitute for character.”² What we need is business leaders with high ethical standards. Independent directors of a board of a public company are the first and best line of defense against dishonest and unethical behavior. We should be focusing on how we attract and retain those types of directors as stewards of our publicly-held companies.

Footnotes:

[1] See FDIC Interpretive Letter FIL-17-2003 (March 5, 2003) in which the FDIC announces that the “provisions of the Sarbanes-Oxley Act represent sound corporate governance practices . . . [and ] the FDIC recommends that each institution consider implementing [a certain selection of them identified by the FDIC] to the extent feasible given its size, complexity, and risk profile.”

[2] March 2002 speech at the Stern School of Business, New York University.