Director action

John Madden and Lisa Toporek take a look at new directions for corporate governance in the US

The recent corporate scandals at companies such as Enron and WorldCom have given rise not only to the perception that the 'gatekeepers', on whom investors rely to assure market integrity, have failed, but also to widespread expectations that new reports of misdeeds are forthcoming. Much attention has been focused on the failure of directors to prevent the recent instances of corporate wrongdoing, despite their fiduciary duties to act in the best interests of the company and its shareholders.
The outcry is having an effect. No longer are public pension funds such as CalPERS and TIAA-CREF alone in sounding the call for corporate governance reform. President George W Bush, Congress, the Securities and Exchange Commission, the New York Stock Exchange (NYSE) and Nasdaq have all announced reform initiatives.
In the weeks following WorldCom's admission that it inflated profits by $3.9bn (£2.47bn), warnings that overbroad reforms may do more harm than good have been largely overtaken by the momentum for significant reform. Many companies have announced their own initiatives, such as General Electric and IBM, which voluntarily decided to provide more detailed financial information in their public reports; and Coca-Cola and The Washington Post Company, which have announced that they would expense the stock options they grant.
Other developing policies that boards should consider include the following:
Board composition
Boards should be composed of highly qualified individuals willing to give the time and effort necessary to be proactive rather than passive directors. No legislative reform initiative can provide an adequate substitute for directors who are actively engaged in the board process.
As recommended by the NYSE, companies should provide detailed orientation sessions for new directors and comprehensive continuing education programmes. Boards should also consider limiting the number of other boards on which its directors may serve.
Nearly all of the boards of leading US companies consist of a substantial majority of non-employee directors, and some companies already require that a substantial majority of their directors be independent, as opposed to the simple majority mandated by the NYSE proposals.
Following criticism of Enron's audit committee (which complied with NYSE independence requirements, but consisted in part of one member who had a consulting agreement with Enron and two members who were employed by universities to which Enron made significant contributions), the NYSE proposals would also tighten the standard of independence for all directors and prohibit audit committee members from receiving any compensation from the company other than directors' fees.
The NYSE proposals require boards to determine that independent directors have no material relationship with the company and impose a five-year 'cooling-off' period before former company and audit firm employees, directors who are part of an interlocking directorate, and immediate family members of the foregoing could be deemed independent.
While tightening the standard of independence, the NYSE proposals would give directors discretion in determining independence, but require companies to disclose determinations that relationships are not material in their annual proxy statements. In assessing independence, boards should focus on all relationships between directors (or any organisation of which a director is a partner, shareholder or officer) and the company; and also consider whether director independence would be enhanced by requiring retirement at a specified age or after a certain term of service (eg 10 years) – whichever comes first.
Board policies and procedures
Boards should adopt comprehensive policies and procedures, most of which should be included in the written corporate governance guidelines that would be mandated by the NYSE proposals. Audit, compensation and nominating committees should be composed solely of independent directors, and independent directors should meet regularly in executive sessions outside the presence of management.
Although a common practice in the UK, few of the leading US companies have formally separated the offices of chairman and chief executive officer (CEO), as advocated by former Federal Reserve chairman Paul Volcker. Notable exceptions include Intel, Cisco and Microsoft. While the NYSE proposals fall short of requiring companies to name lead independent directors, disclosure of the name of the director presiding at executive sessions would be required. Boards should consider whether their effectiveness would be enhanced by naming a lead independent director and giving that director responsibilities in addition to presiding at executive sessions.
Because director performance is directly related to the quality of information and advice that directors receive, companies should ensure that directors receive timely, thorough and well-prepared information sufficiently in advance of meetings. Directors should also have access to outside professional advisers, including outside legal counsel, as well as management. For ease of administration, companies should consider whether directors' access to management should be direct or through the CEO or another executive.
Board evaluation and compensation
Boards should annually review their performance and consider whether evaluation of individual director performance would also be useful. Nearly all of the largest US companies provide their directors with some form of equity compensation. To align directors' interests with those of long-term investors, boards should consider requiring directors to own a minimum amount of stock and impose some limitations on directors' sales of stock during their tenure on the board.
Audit committee responsibilities
Audit committees should provide an oversight of not only the internal and external audit processes, but also related party transactions and risk management. To ensure that the authority of audit committees with respect to the independent and internal auditors is clear, committees should have the sole authority to hire and fire the independent auditor, as would be required by the NYSE proposals, and be substantively involved in the selection and review of senior executives in charge of internal audit functions.
Given the breadth and depth of the issues they must consider, audit committees should meet regularly and consider having no preset limit on the duration of their meetings. Audit committees should also meet regularly in separate executive sessions with management, the independent auditor and internal auditors.
Auditor independence
To preserve the integrity of the audit process, audit committees should implement policies to ensure auditor independence. Several companies, including Disney, Motorola and JPMorgan Chase, have restricted the non-audit services their independent auditors may provide. Legislation recently passed by the US Senate would also restrict the performance of certain non-audit services, such as financial information systems' design and implementation and internal audit outsourcing by independent auditors for their audit clients.
Rather than restricting specific non-audit services, the NYSE proposals require that audit committees have the sole authority to approve any significant non-audit relationship with the independent auditor. Emerging best practices would suggest that audit committees consider policies prohibiting independent auditors from providing certain non-audit services and pre-approve all non-audit services to be performed by the independent auditor above an established threshold amount. No members of the audit team should receive compensation based upon non-audit services.
Audit committees should also develop policies on audit firm rotation and hiring audit firm employees. As indicated by the legislation, no consensus on mandatory audit firm rotation has emerged that would require a study on the effect of government-mandated audit firm rotation. However, there is a consensus that lead audit partners should be rotated periodically – a practice already followed by many audit firms and included in the legislation.
The NYSE proposals would require audit committees to set clear hiring policies for current and former audit firm employees. Audit committees should consider imposing a 'cooling-off period', whereby members of the independent audit team, at least for some period of time, could not be hired. They should also review any proposed hires of audit firm employees for senior positions, regardless of whether such employees worked on the company's audit team.
As boards have begun to review their own governance practices, they have increasingly called upon law firms to examine their current practices and to recommend modifications to enhance board effectiveness.
However, in order to establish the standards of integrity and effectiveness necessary to restore investor confidence, individual directors must make a personal commitment to dedicate the time and effort necessary to actively pursue their role as gatekeepers and to fully discharge the responsibilities they have to shareholders. No legislative or regulatory reform initiative can be an adequate substitute for this substantive commitment by individual directors.
John Madden is a partner and Lisa Toporek an associate at Shearman & Sterling